CNBC Explains

Private Equity: CNBC Explains

Private equity is not the name of a soldier in the U.S. Army (though there is a connection of sorts as we'll see later). No, it's a way of doing business to make money for large investments of capital.

So what is private equity and how does it work? CNBC explains.

What is private equity?

It's a source of investment capital from high net worth individuals with the goal of investing and acquiring equity ownership in companies. The investment in those companies will generally be made by a private equity firm, but also by a venture capital firm or an angel investor.

In simpler terms, the idea behind private equity is to gather up funds from a number of investors, take those funds and use them to acquire a controlling or substantial minority position in a firm, and then get a return on that investment.

The targeted companies of private equity are not usually publicly traded on the stock market— or if they are, are usually de-listed from the markets in order to make the private deal. The firms can be listed again, usually as a way to make money for the private equity investors, as we'll note in a bit.

How does private equity fund actually acquire a firm?

The most common way is through the leveraged buyout or LBO. This is the takeover of a company—part of it or some of the firm's assets -- using private equity funding as well as using borrowed funds from banks. The funds can be used to buy up all the company's shares if it's public — and then its taken private — or the money is used to buy out the firm's owners if it's not a public firm.

Other ways private equity can be used to take over a firm include using the funds to grow a firm, or to pay off a debt, and thus giving the private equity holders control of the company in each case.

How do private equity investors make money back?

They generally receive a return on their investments through one of the following ways:

  • An initial public offering (IPO). Shares of the company are offered to the public, typically providing an immediate return on an investment through the sale of shares in the firm.
  • A merger or acquisition: the company is sold for either cash or shares in another company.
  • A recapitalization: cash is distributed to the shareholders — the investors — either from cash flow generated by the company or through raising debt or other securities to fund the distribution.

When did private equity begin in the U.S.?

Private equity investment goes back as far as 1901 when J.P. Morgan is said to have managed the first leveraged buyout of the Carnegie Steel Company using private equity. Up until World War II, most private equity investments were in the hands of wealthy individuals or families.

But modern day private equity is commonly said to have begun in 1946 and credited to Georges Doriot, the "father of venture capitalism" with the founding of ARDC and founder of INSEAD, with capital raised from institutional investors, to encourage private sector investments in businesses run by soldiers who were returning from World War II.

ARDC is credited with the first major venture capital success story with its 1957 investment of $70,000 in Digital Equipment Corporation would be valued at over $355 million after the company's initial public offering in 1968.

What are some of the current bigger private equity firms?

The largest private equity firms based on how may funds they attract include: Bain Capital, Goldman Sachs, The Carlyle Group, Kohlberg KravisRoberts, and The Blackstone Group.

What are the pros and cons of private equity?

Critics say that in order to increase their investment with a fast sale of the firm they now control, private equity investors often replace senior management, reduce the workforce and sell off assets—and essentially gut the company for profit.

Backers of private equity say it attracts the best and brightest in corporate America, and the professionals at these firms are usually successful with increasing the values of the companies they control or eventually sell.