What is Private Equity?

A group of partners with various skills like an accountant, an attorney, a salesman, and a marketing person (and other skills) gets together and create a partnership that will become the management team.  This management team starts a fund that has a name and is open to investors for a limited time.   This team then goes around and sells their services as ‘the smartest guys in the room’ to raise money from qualified* investors.   Once they have the money from investors, the management team have successfully created a Private Equity Fund.

*What is a qualified investor?  These are investments are only available to ‘sophisticated investors’ a who have a significant net worth.  These investors can be pension funds (public or private), banks, endowments and wealthy families.

Why would investors want to invest money with this group?  Because the investors believe the management group have something called ‘edge’ or ‘alpha’.   This is slang for they ‘outperform the market’ and will make TONS OF CASH for the investors.  That is always the reason.

Once the private equity fund has the investor’s money, the private equity partners have to begin working their magic. Now is the time to put the plans into action.  The private equity partners take the investment money and they usually buy, start, or otherwise expand private businesses for a profit.

As an example: Let’s say there are 1,000 bowling alleys in Illinois and they’re all owned by ‘mom and pop’ type of owners.      You could have a strategy to go in and buy 50% of the bowling alleys in Illinois and create a regional bowling brand.   You could market them across new channels and lower the cost of getting a new bowler in the door.  You could match their interior design and upgrade their facilities so people feel comfortable visiting other bowling alleys.  You could increase the revenue by raising prices across all of the bowling alleys at once.  You could lobby for some sort of a bowling alley reprieve on property taxes from the State Legislature.  You could standardize their computers and the bowling pins.   The point is that the 500 bowling alleys working together could have some economies of scale and save money for the private equity managers and their investors.

Once private equity managers have created a reliable revenue stream from managing these businesses, they have created something of value.   Their customers value their products and the reliable and growing revenue stream from those customers can be sold for a profit.

There are various ways for private equity to get the cash back out of the businesses.   This is the end game.   Their investors didn’t want to own a bunch of bowling alleys forever, they were looking to make a profit on their initial investment.

Some of the ways these businesses are converted to cash can include being sold to larger companies. or going public and having their stock is sold on stock exchanges. Those who invest in private equity deals are told that their investment takes time to pay off.   You’re supposed to be patient with your investment.   That’s what they say.  The returns can be ‘lumpy’.   Up one year and down the next.

Now the real story: