What is Private Equity?

by alexvanbuskirk

American Restoration: The Role of Private Equity

By J.D. Foster, Ph.D. @ The Heritage Foundation (May 23, 2012)

Private equity firms buy companies. But not just any companies. They don’t buy flourishing companies at peak prices. There’s no profit there. Private equity firms buy companies that are failing or substantially underperforming for some reason—companies with managements that lack the knowledge or capacity, financial, managerial, or otherwise, to turn the companies around. Private equity firms often have that knowledge and capacity.

Because a company bought by a private equity firm is often struggling, the sale price is often fairly low. After all, no one can get a high price for a company heading for mediocrity or closure. And if the private equity firm can use its own expertise and resources to heal the company, then after a few years the company is sold again for a profit.

Maybe the problem is old production methods and a lack of expertise about state-of-the-art processes. Maybe the product line is cluttered but management can’t decide what to keep and what to drop. Maybe the management systems prevent timely decision making. Maybe the company’s financial structure is unsound. In some cases, there may be too many employees or, more often, the wrong employees in terms of skills and aptitudes. Whatever the problems, if under the flaws remains something of real value, then with the right tools, that value can be brought to the surface again. Private equity provides those tools.

Another distinguishing feature of private equity firms is that they raise their own capital. They are primarily risking their own money. However, private equity firms are generally not buy-and-hold investors. They buy, fix, and sell. And when they get it right, the company is better positioned to grow and create new jobs, and the private equity firms can make a lot of money.

But they don’t always make money. Sometimes the company’s problems run too deep, so a company destined for closure still winds up closed. This is a risky businesses, and risk means not just that the profits are uncertain but that losses are occasionally inevitable.