Private equity

Based on Wikipedia: Private equity

The Art of Buying Companies with Other People's Money

Imagine you want to buy a house that costs a million dollars, but you only have a hundred thousand. You borrow the rest from a bank, fix up the house, and sell it for one and a half million. After paying back the loan, you've turned your hundred thousand into five hundred thousand. That's a five-fold return on your money, even though the house only increased fifty percent in value.

This is the basic magic trick of private equity.

Private equity firms buy entire companies using mostly borrowed money, improve those companies—or at least try to—and then sell them at a profit. The "private" part means these companies don't trade on public stock exchanges like the New York Stock Exchange or the Nasdaq. They're privately held, away from the scrutiny of quarterly earnings reports and the whims of day traders.

The Players in This Game

A private equity fund works like this: A group of experienced dealmakers—let's call them the general partners—raise money from large institutional investors. These investors include pension funds managing retirement savings for teachers and firefighters, university endowments funding scholarships, hedge funds looking to diversify, and extraordinarily wealthy individuals. These investors become limited partners, meaning their liability is capped at the money they invest.

The general partners then go shopping for companies to buy.

They're typically looking for businesses that are underperforming but not hopeless—companies with solid bones but sloppy management, or businesses that could grow faster with more capital and better strategy. Sometimes they're looking for companies that can be broken apart and sold in pieces worth more than the whole.

Here's what makes the structure elegant, or troubling, depending on your perspective: the debt used to buy the company doesn't sit on the private equity fund's books. It goes on the acquired company's books. The company itself becomes responsible for paying back the loans used to purchase it.

The Leveraged Buyout: A Case Study

Let's walk through a simplified example to see how this works in practice.

A private equity fund called, say, ABC Capital, wants to buy XYZ Industrial, a manufacturer that's been treading water for years. The purchase price is eleven billion dollars. ABC Capital borrows nine billion from banks and puts in two billion of its own equity—money pooled from its limited partners and general partners.

Now ABC Capital owns XYZ Industrial. The new owners replace the chief executive officer and much of the senior management team. They cut the workforce, sell off underperforming divisions, renegotiate contracts with suppliers, and implement cost-cutting measures across the organization.

Two years later, the stock market is booming and the newly streamlined XYZ Industrial is sold for thirteen billion dollars. After paying back the nine billion loan plus about half a billion in interest, ABC Capital is left with a profit of one and a half billion dollars. They turned two billion into three and a half billion in just two years.

That's a seventy-five percent return on invested capital.

Notice something important here: the profit came from two sources. Part of it came from genuinely improving the company—making it more efficient, more profitable, more valuable. But part of it simply came from the stock market going up. During bull markets, all ships rise with the tide, and private equity funds often benefit enormously from timing that has nothing to do with their operational skills.

The Leverage Effect: A Double-Edged Sword

The use of debt—leverage, in financial parlance—is what makes private equity returns so potentially spectacular. It's simple arithmetic: if you buy something for one hundred dollars of your own money and sell it for one hundred and twenty, you've made twenty percent. But if you buy that same thing with ten dollars of your own money and ninety dollars borrowed, then sell it for one hundred and twenty, pay back the ninety, and you've turned ten dollars into thirty. That's a two hundred percent return.

Leverage amplifies everything.

The problem is that leverage amplifies losses just as effectively as it amplifies gains. If that company you bought goes bankrupt, you lose your entire investment. The limited partners lose their money. The general partners lose their fees and their reputation. And the company's employees, who had nothing to do with any of this financial engineering, lose their jobs.

Following a series of spectacular bankruptcies—think Toys "R" Us, which collapsed in 2017 under the weight of debt loaded onto it by its private equity owners—the industry has become somewhat more conservative. In 2005, about seventy percent of a typical private equity acquisition was financed with debt. By 2020, that figure had dropped closer to fifty percent. Still substantial, but less aggressive.

The Tax Advantage You Might Not Know About

There's another reason private equity loves debt, and it has nothing to do with amplifying returns. Interest payments on debt are tax-deductible.

When a company makes a profit and pays it out as dividends to shareholders, that money gets taxed twice: once as corporate income, and again as personal income to the shareholders. But when a company pays interest on its debt, that interest reduces the company's taxable income. The tax savings are real and substantial.

This creates an interesting incentive: the tax code essentially subsidizes debt-financed acquisitions. Whether this is good policy is hotly debated, but it's undeniably part of why private equity structures work the way they do.

Beyond the Buyout: Other Flavors of Private Equity

While leveraged buyouts get most of the headlines, private equity is actually an umbrella term covering several different investment strategies.

Growth capital is perhaps the gentlest form. Here, private equity investors take a minority stake in a company that's already successful but needs capital to expand. Maybe a regional restaurant chain wants to go national, or a software company needs to fund a major product launch. The owners don't want to sell the whole company, and they don't want to go public with all the regulatory burdens that entails. Growth capital offers a middle path.

Venture capital is private equity for the young and unproven. Venture capitalists fund startups—companies that might not yet have revenue, let alone profits. They're betting on ideas, on technology, on founders with vision. Most venture investments fail completely. But the ones that succeed—the Googles and Facebooks and Amazons—can return hundreds of times the original investment, more than making up for the failures.

Mezzanine capital occupies a strange middle ground between debt and equity. It's subordinated debt, meaning it gets paid back after regular loans but before equity holders. Or it might be preferred stock, which has characteristics of both. Companies use mezzanine financing when they've already borrowed all they can from banks but still need more capital. The mezzanine lenders know they're taking more risk, so they demand higher returns.

Distressed investing is for the vultures. These investors specialize in buying the debt of companies that are failing or have already failed. They might buy bonds trading at thirty cents on the dollar, then either push the company into bankruptcy to seize its assets, or work out a restructuring where they convert their debt into equity ownership. When it works, distressed investing can be extraordinarily profitable. It can also be extraordinarily contentious.

Platform Companies and Bolt-On Acquisitions

Private equity firms don't just buy companies and hope for the best. They often have explicit strategies for how they plan to create value, and one of the most common involves a concept called "buy and build."

First, they acquire what they call a platform company—a solid business with good management, established operations, and room to grow. This becomes the foundation.

Then they start adding bolt-on acquisitions: smaller companies in the same industry or adjacent markets. Each bolt-on might add new capabilities, new customer relationships, new geographic coverage, or simply more scale. Private equity firms often pay lower valuations for smaller companies than for larger ones, so rolling up multiple small companies into one larger entity can create value purely through financial engineering.

A private equity firm might buy a mid-sized heating and air conditioning company as their platform, then acquire dozens of smaller local HVAC businesses across the country. Each acquisition adds technicians, trucks, customer contracts, and revenue. The combined entity has more negotiating power with suppliers, can invest in better technology systems, and might eventually be sold to an even larger strategic buyer—or taken public.

Who Actually Benefits?

This is where private equity becomes genuinely controversial.

Supporters point to genuine value creation. Private equity firms bring professional management to companies that need it. They invest capital in growth. They impose discipline on bloated organizations. They take risks that more cautious investors won't. The industry employs thousands of talented people and generates substantial returns for pension funds—meaning teachers and nurses and police officers benefit from successful private equity investments.

Critics see something darker. They see financial engineering masquerading as value creation. They see companies loaded with debt they can't support, jobs eliminated to juice short-term profits, and communities devastated when overleveraged businesses collapse. They see a fee structure that enriches general partners regardless of whether limited partners make money. They see a tax system that privileges this kind of investing over simply running a good business.

The empirical evidence is genuinely mixed. Some studies find that private equity-owned companies grow faster and become more productive. Others find that they're more likely to go bankrupt, more likely to lay off workers, and no more profitable than comparable public companies once you adjust for the extra risk.

The Syndicate: When Giants Team Up

The largest private equity deals are often too big for any single firm to swallow. When the deal size runs into the tens of billions of dollars, private equity firms form syndicates—temporary alliances that combine their capital and expertise.

There are several advantages to this approach. Risk diversification is the most obvious: instead of betting everything on one mega-deal, each firm can participate in multiple large transactions. But syndication also brings together different areas of expertise—one firm might excel at operational turnarounds while another has deep relationships with lenders. And there's a networking benefit: firms that work well together on one deal are more likely to collaborate on future opportunities.

Some of the most famous private equity transactions in history were syndicate deals. The 2007 buyout of Energy Future Holdings, a Texas utility company, involved Kohlberg Kravis Roberts, Texas Pacific Group, and Goldman Sachs. At forty-five billion dollars, it was one of the largest leveraged buyouts ever. It was also a disaster—the company filed for bankruptcy in 2014, one of the biggest in American history.

The Mathematics of Returns

Private equity investors obsess over four primary drivers of return, often expressed through the somewhat ungainly language of finance.

First, revenue growth. Can they sell more stuff? This might mean expanding into new markets, launching new products, or simply selling harder to existing customers.

Second, margin expansion. Can they keep more of each dollar of revenue? This typically means cutting costs—reducing headcount, renegotiating supplier contracts, consolidating facilities, eliminating waste.

Third, debt paydown. As the company generates cash and pays down its debt, more of the company's value accrues to the equity holders. It's like paying down your mortgage: each payment increases your ownership stake in your home.

Fourth, multiple expansion. This is the trickiest one to explain. Private equity firms often value companies as a multiple of their profits—specifically, a measure called EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. A company might be worth eight times its EBITDA when you buy it, but ten times its EBITDA when you sell it. That multiple expansion alone represents a twenty-five percent increase in value, even if the underlying business hasn't changed at all.

Multiple expansion is partly about improving the business—better-run companies tend to command higher multiples—but it's also heavily influenced by market conditions. In a hot market, buyers pay higher multiples. Private equity firms that buy low and sell high benefit enormously from timing, which critics argue is essentially luck dressed up as skill.

Where This Fits in the Financial Universe

Private equity occupies a specific niche in the investment landscape. It's less liquid than public stocks—you can't just sell your stake whenever you want. Most private equity funds lock up investor capital for seven to ten years. It's more risky than bonds, with a real chance of losing your entire investment. But for investors who can accept those constraints, private equity has historically offered higher returns.

Or at least, it used to.

In recent years, the sheer amount of money flowing into private equity—trillions of dollars seeking deals—has compressed returns. When too much capital chases too few good opportunities, prices get bid up and returns suffer. Some recent studies suggest that average private equity returns no longer beat the stock market, once you account for the extra risk and illiquidity.

Venture capital, in particular, has seen declining returns for most investors. The very best venture funds still generate spectacular returns, but the median fund has underperformed public markets for much of the past decade. The winners in venture capital are those who can get access to the top-tier funds—and those funds are typically closed to new investors.

The Human Cost

Behind the financial abstractions are real companies with real employees. A factory worker in Ohio doesn't particularly care whether the company is publicly traded or owned by a private equity fund—until it matters.

The evidence suggests that private equity ownership tends to increase job losses, at least in the short term. Cost-cutting is one of the primary tools for improving profitability, and labor is typically the largest cost. When private equity takes over a company, layoffs often follow.

Whether these job losses are cruel or necessary depends on your perspective. Sometimes companies really are overstaffed, and trimming the workforce makes the company more competitive and sustainable. Sometimes private equity firms extract wealth from companies in ways that leave them weakened, benefiting investors at the expense of workers and communities.

The retail sector provides sobering examples. Toys "R" Us, Payless ShoeSource, Gymboree, RadioShack, Sports Authority—all went bankrupt under private equity ownership, loaded with debt they couldn't service. Were these companies doomed anyway, victims of Amazon and changing consumer preferences? Or did private equity hasten their demise while extracting fees along the way? Probably both, in varying proportions.

Looking Forward

Private equity has grown from a niche strategy to a dominant force in the investment world. Trillions of dollars are now managed by private equity firms. The largest firms—Blackstone, Apollo, Kohlberg Kravis Roberts, Carlyle—are themselves publicly traded companies worth tens of billions of dollars.

The industry faces headwinds. Rising interest rates make leverage more expensive. Increased regulatory scrutiny threatens the favorable tax treatment that has benefited the industry. Competition for deals has pushed valuations higher and expected returns lower.

But private equity has proven remarkably adaptable. When leveraged buyouts became less attractive, firms moved into growth equity and venture capital. When American markets became crowded, they expanded internationally. When traditional industries matured, they moved into technology and healthcare. When public markets became volatile, more companies chose to stay private longer—creating more opportunities for private equity.

For better or worse, private equity has become a permanent and powerful feature of modern capitalism. Understanding how it works is essential for understanding how companies get bought and sold, how capital gets allocated, and how wealth gets created—or destroyed.