Role of Private Equity Firms

Private equity firms are specialists in leveraged buyouts.

Private equity firms are investment companies that invest in privately held or publicly traded companies that have an operating history of at least five years. Private equity firms are also called leveraged-buyout firms because they typically buy companies using a very limited amount of their own cash (small equity positions of no more than 20 percent). The remainder of the purchase price for the acquired company will be some form of debt, usually a combination of bank loans, notes or bonds.

In Search of Underperforming Companies

Private equity firms hunt for underperforming companies to buy.

Typically, private equity firms are on the hunt for sluggish, underperforming companies within their respective industries that have terrific underlying value in terms of increased valuation potential with an improvement in the firm's operating performance.

Increased valuation potential might be a function of strategic positioning regarding market potential, product uniqueness or patents, generous management incentives, or financial enhancements to optimize cash flow. Or it can be divestment potential, if the value of parts of the acquired company is greater than the value of the company itself. These and other factors can make a firm an ideal candidate for a leveraged buyout.

Pool of Private Investors

Private equity firms help keep some pension checks coming.

Private equity firms constitute a pool of private investors, typically referred to "limited partners," who enter into a partnership with the general partner, typically the managing principals of the private equity firm, in anticipation of generating very significant returns on their investment. The limited partners are usually large institutional investors with an overabundance of money to invest, such as pension funds, university endowment funds, insurance companies and large money management funds.

Because of the outsized return on investment, private equity firms might be considered extremely attractive for high-net-worth individuals and institutional investors having a fiduciary responsibility to their constituents, such as pensioners. They provide investment opportunities that otherwise would be unavailable to most institutions.

Great for Institutional Investors

Private equity firms drive increased value of the firms they buy.

Private equity firms earn their money as a function of capital gains--the increase in the value of the acquired firm. They realize their "profit" on the back end in fulfillment of their "exit strategy," either through the sale of the acquired company to another private party or through an initial public offering.

In a nutshell, private equity firms buy companies using very little of their own money, by borrowing large amounts. They improve the operations of the acquired firm, pay down the debt, and then exit within a few years with a hefty profit. So goes the theory.

Significance of Sarbanes-Oxley

With the enactment of the Sarbanes-Oxley Act of 2002, the management of publicly held companies is severely restricted in the stewardship of the resources of the companies they manage and the manner in which they report the financial statements. These constraints often lead to inaction, missed opportunities, neglect of plant, equipment and marketing, and other maladies that can compromise a firm's competitiveness.

Aggressive Performance Improvement

Private equity shareholders are not constrained by Sarbanes-Oxley. Despite their status as "investors," they actually act like owners by becoming proactively involved in management. They are typically nimble in rapidly responding to problems and changes in the competitive environment. Their driving mantra is to rapidly and aggressively improve the performance of the firms they acquire so they can execute their exit strategy as quickly as possible, usually within three to five years.

References

• The Role of Private Equity Firms in M&A Acquisitions
• The Rising Role of Private Equity
• Bain executives discuss the role of private equity and its future