Private Equity Firms, Funds, and Their Role in the Financial Crisis

Multi-billion Dollar Deals That You Can't Even Invest In

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Private equity is private ownership, as opposed to stock ownership, of a company. Private equity investors can buy all or part of a private or public company, and they usually have a 5 to 10-year time horizon for which they want to keep their investment before selling. Private equity firms typically look for about a $2.50 return for every dollar invested. 

Since private equity investments have a longer time horizon than typical stock investors, private equity can be used to fund new technologies, make acquisitions, or strengthen a balance sheet and provide more working capital. Private equity investors hope to beat the market in the long run by selling their ownership at a great profit either through an initial public offering or to a large public company.

If all of a public company is bought, it results in a delisting of that company on the stock exchange. This is called "taking a company private." It's usually done to rescue a company whose stock prices are falling, giving it time to try growth strategies that the stock market may not like. That's because private equity investors are willing to wait longer to obtain a higher return, while stock market investors generally want a return that quarter if not sooner.

Private Equity Firms

These private stakes in a company are usually bought by private equity firms. Firms can keep the holdings, or sell these stakes to private investors, institutional investors (government and pension funds), and hedge funds. Private equity firms can either be privately held, or a public company listed on a stock exchange.

The private equity business is dominated by well-capitalized investors who are looking for big deals. In fact, the top 10 firms own half of the worldwide private equity assets. Here's a list of the top 10 firms in 2017 and the amount of capital raised over a five-year period:

  1. Blackstone Group - $58.32 billion 
  2. Kohlberg Kravis Roberts - $41.62 billion
  3. Carlyle Group - $40.73 billion
  4. TPG Capital - $36.05 billion
  5. Warburg-Pincus - $30.81 billion
  6. Advent International - $26.95 billion
  7. Apollo Global Management - $23.99 billion
  8. EnCap Investments - $21.22 billion
  9. Neuberger Berman Group - $20.39 billion
  10. CVC Capital Partners - $19.89 billion

Private Equity Funds

The money raised by private equity firms is put into private equity funds. These funds are usually structured as limited partnerships, with a duration of 10 years. The funds typically have annual extensions, and the money comes mainly from institutional investors, like pension funds, sovereign wealth funds, and corporate cash managers, as well as family trust funds and even wealthy individuals. It can include cash and loans, but not stocks or bonds.

A private equity firm typically manages several distinctly different funds, and will attempt to raise money for a new fund every three to five years, as the money from the previous fund is invested.

Problems Hidden in Private Equity Financing

Private equity firms use the cash from their investors to purchase whole or partial interests in companies. The return on those investments, called the internal rate of return, attracts new investors and defines the success of the firm.

But private equity firms have found a way to artificially boost that IRR. Since interest rates are so low, they borrow funds to make a new investment. After holding the investment for a while, they use investors' cash to pay off the loan and take ownership of the asset when it looks like the investment is about to pay back. As a result, it looks like the investors received a huge return in a short period. The IRR looks much better, thanks to the use of borrowed funds.

How Private Equity Helped Cause the Financial Crisis

According to Prequin.com, $486 billion of private equity funding was raised in 2006. This additional capital took many public corporations off the stock market, thus driving up the share prices of those that were left. In addition, private equity financing allowed corporations to buy back their own shares, also driving remaining share prices up. 

Many of the loans that banks make to the private equity funds were then sold as collateralized debt obligations. Because of this, the banks didn't care if the loans were good or not. if they were bad, someone else was stuck with them. In addition, the impact of these loans going sour was felt in all financial sectors, not just banks. The excess liquidity created by private equity was one of the causes of the 2007 Banking Liquidity Crisis and subsequent recession. (Source: Prequin, Private Equity Spotlight October 2007.

Simon Clark, "Blackstone Wants More Range to Buy," Wall Street Journal, February 26, 2015)