The private equity industry has received quite a bit of bad press over the past few months. The UK, The Netherlands and Australia have held parliamentary inquiries to investigate private equity’s effects on the economy. Newspaper commentators and columnists have expressed their criticism claiming that private equity firms evade taxes, destroy jobs, burden the companies they buy with debt, strip their assets and drain their profits before offloading them again. Yet few people seem to understand how private equity actually works and why it has taken such a great flight in recent years. And no, Wikipedia doesn’t explain it either.

Private equity is an equity investment in a company not listed on a stock market. It is an equity investment in that the investor acquires a stake in the company, becoming a partial or full owner. As such the private equity investor is entitled to a share in the company’s profits.

If private equity is used to invest in a start-up company it is often referred to as venture capital. If the start-up company becomes a success, think Google, Ebay, Amazon, the profits can be substantial. However, many start-ups fail, which is why venture capital is generally perceived as risky.

Private equity can also be used to assist a company’s management to buy the company from its owners, a so called “management buy-out”, and to buy up all of the publicly traded shares of a listed company. It is the practice of buy-outs, often by issuing debt, hence the name “leveraged buy-out”, that has become synonymous with private equity and that is currently under scrutiny.

After gaining some notoriety in the 1980s with the (in)famous leveraged buyout of RJR Nabisco by Kohlberg Kravis Roberts & Co (KKR), one of the largest private equity firms, and the coining of the term “corporate raider”, private equity had more or less vanished from the public radar. That is, until the acquisition of some big listed companies by private equity firms, this and last year, suddenly made news headlines.

But how does private equity work? The following is a standard, textbook example that every economics student will or should be familiar with.

Suppose a company makes an annual profit of 10 million USD and is acquired by a private equity firm for 100 million USD, that is, at a price earnings ratio of 10, meaning that the private equity firm is willing to pay 10 times the company’s annual profit. To acquire the company the private equity firm invests 30 million USD of its own capital borrowing the remaining 70 million USD.

Now suppose that three years later the company still makes a profit of 10 million USD per year. The private equity firm has used the profits to repay 30 million USD of the loan (I’m abstracting from taxes here) and decides to sell the company for the same price as it has bought it, that is, 100 million USD. This may seem like a bad deal, but take a closer look at what happens. The private equity firm uses 40 million USD to repay the remainder of the loan and is left with 60 million USD. Thus, in three years the firm has doubled its initial investment of 30 million USD!

If the private equity firm manages to reduce costs and increase the company’s annual profits to 16 million USD, to keep things simple, and sells it again with a price earnings ratio of 10, that is, for 160 million USD, the profit for the private equity firm is 90 million USD (after repaying the 70 million USD loan), three times the initial investment. If, because of the increase in profits, it can convince buyers of a higher price earnings ratio, it will earn even more.

So, in this simplified example, regardless of whether the company being acquired is “turned around”, the private equity firm makes a substantial profit on its investment. The reason? Its ability to finance part of acquisition with debt.

The low and stable interest rates of the past few years have made it easy for private equity firms to borrow money. The fact that interest payments are tax deductible makes the entire construction even more attractive.

I've added links to some recent papers:

Andrew Metrick and Ayako Yasuda (2010). The economics of private equity funds.

Steven N. Kaplan and Per Johan Strömberg (2008). Leveraged Buyouts and Private Equity.

Ulf Axelson, Per Stromberg and Michael S. Weisbach (2008). Why are Buyouts Levered? The Financial Structure of Private Equity Funds. Journal of Finance 64 (4), pp. 1549-1582.