Definition
A private equity firm is an investment firm that seeks to make high returns by:
- Obtaining a controlling interest in a target company, often through a leveraged buyout (LBO). If the target company is public, it is then taken private.
- Subjecting the acquired company to significant financial and organizational restructuring over several years to maximize profitability.
- Eventually selling the restructured, revitalized company or floating it on the stock exchange to realize capital gains.
Most private equity investments are funded by debt, making these acquisitions highly leveraged.
Examples
- The Carlyle Group: An example of a notable private equity firm that has invested in diverse sectors, from aerospace to technology.
- KKR & Co. Inc.: Known for its pioneering leveraged buyouts, KKR has acquired companies like RJR Nabisco and Toys “R” Us.
- Blackstone Group: A leading private equity investor, Blackstone has holdings in real estate, hospitality, and various other industries.
Frequently Asked Questions
What is a leveraged buyout (LBO)?
A leveraged buyout (LBO) is a transaction where a company is acquired using a significant amount of borrowed money. The assets of the company being acquired often serve as collateral for the loans.
How do private equity firms profit?
Private equity firms profit by increasing the value of the companies they acquire through strategic management and operational improvements. They then sell these companies or take them public at a higher valuation.
What is meant by “taking a company private”?
This phrase means that the company stops being publicly traded and its shares are no longer available on public stock exchanges. The ownership becomes concentrated among private equity investors.
Are private equity investments risky?
Yes, private equity investments carry high levels of risk due to the significant use of debt (leverage) and the challenges of turning around underperforming companies.
What is the controversy surrounding private equity firms?
Critics accuse private equity firms of having an “asset-stripping” mentality, where companies are bought, valuable assets are sold off, and the remaining entity is left in a weakened condition. Concerns also exist about unfair tax advantages and lack of transparency.
Related Terms & Definitions
- Management Buy-In (MBI): When external managers buy into a company as part of a private equity transaction.
- Management Buy-Out (MBO): When existing managers buy out the ownership interest of the company they manage.
- Asset Stripping: The practice of selling off a company’s assets individually to maximize value.
- Leveraged Buyout (LBO): A strategy where a company is purchased using borrowed funds.
- Initial Public Offering (IPO): The process of offering shares of a private corporation to the public in a new stock issuance.
Online References
- Private Equity on Investopedia
- The Harvard Law School Forum on Corporate Governance
- The National Venture Capital Association (NVCA)
Suggested Books for Further Studies
- “Private Equity at Work: When Wall Street Manages Main Street” by Eileen Appelbaum and Rosemary Batt.
- “King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone” by David Carey and John E. Morris.
- “Private Equity: History, Governance, and Operations” by Harry Cendrowski, James P. Martin, Louis W. Petro, Adam A. Wadecki.
Accounting Basics: “Private Equity Firm” Fundamentals Quiz
### What is the primary goal of a private equity firm when it acquires a company?
- [ ] To maintain the status quo.
- [x] To restructure and increase profitability.
- [ ] To immediately sell off all assets.
- [ ] To list it on the stock exchange without changes.
> **Explanation:** The primary goal is to restructure and increase the profitability of the company before selling it or floating it on the stock exchange for a higher valuation.
### What is a leveraged buyout (LBO)?
- [x] Acquiring a company using borrowed money.
- [ ] Lending money to a company for expansion.
- [ ] Buying shares of a company on the stock exchange.
- [ ] Merging two companies to create a leverage.
> **Explanation:** A leveraged buyout involves acquiring a company using a significant amount of borrowed money, often backed by the assets of the company acquired.
### What happens when a public company is taken private?
- [x] Its shares are no longer publicly traded.
- [ ] It undergoes an initial public offering (IPO).
- [ ] It merges with another public company.
- [ ] It files for bankruptcy.
> **Explanation:** When a public company is taken private, its shares are no longer traded on public stock exchanges and ownership becomes concentrated among private investors.
### Who typically funds the majority of a private equity acquisition?
- [ ] Government grants.
- [ ] Personal savings of CEOs.
- [x] Debt from financial institutions.
- [ ] Shareholder equity.
> **Explanation:** The majority of private equity acquisitions are funded by debt, making these transactions highly leveraged.
### Which phase does a private equity firm undergo after acquiring a company?
- [ ] Liquidation.
- [ ] Status Quo Maintenance.
- [ ] Operational Integration.
- [x] Financial and organizational restructuring.
> **Explanation:** After acquiring a company, a private equity firm undertakes financial and organizational restructuring to enhance the company's profitability and value.
### What criticism is often directed at private equity firms?
- [x] Asset stripping.
- [ ] Overpaying for companies.
- [ ] Excessive transparency.
- [ ] Underuse of leverage.
> **Explanation:** Critics often accuse private equity firms of asset stripping, where valuable assets of the acquired company are sold off, potentially leaving the company in a weakened state.
### Which of the following is a common private equity exit strategy?
- [x] Initial Public Offering (IPO).
- [ ] Continuing ownership indefinitely.
- [ ] Ceasing all company operations.
- [ ] Selling personal assets.
> **Explanation:** A common exit strategy for private equity firms is an Initial Public Offering (IPO), where they can sell shares of the company to the public to realize capital gains.
### How does a private equity firm typically increase the value of an acquired company?
- [ ] By maintaining its current operations.
- [ ] By large-scale firing of all staff.
- [x] Through strategic management and operational improvements.
- [ ] By dissolving the company.
> **Explanation:** Private equity firms typically increase value via strategic management and operational improvements aimed at enhancing profitability.
### What key strategy differentiates private equity from other forms of investment?
- [ ] Use of shareholder voting rights.
- [ ] Investment in nonprofit organizations.
- [x] Heavy use of leverage for acquisitions.
- [ ] Avoiding public markets.
> **Explanation:** The heavy use of leverage (borrowing money to finance acquisitions) is a key strategy that differentiates private equity from other types of investments.
### What is a common concern regarding the tax treatment of private equity firms?
- [x] Unfair tax advantages.
- [ ] High corporate tax rates.
- [ ] Excessive taxation of private equity employees.
- [ ] Lack of any tax-deferral options.
> **Explanation:** A common concern is that private equity firms enjoy unfair tax advantages, which critics believe allows them to avoid paying a fair share of taxes.
Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
