Private Equity Firms, Funds, and Their Role in the Financial Crisis
Multi-billion Dollar Deals That You Can't Even Invest In
Private equity is private ownership, as opposed to stock ownership, of a company. The private equity investors can buy all or part of a private or public company. Private equity investors usually have a 5 to 10-year time horizon. They typically look for a $2.50 return for every dollar invested.
Since it has 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 2016 and the capital raised in the last decade.
- Carlyle Group - $66.7 billion
- Blackstone Group - $62.2 billion
- Kohlberg Kravis Roberts - $57.9 billion
- Goldman Sachs - $55.6 billion
- Ardian - $53.4 billion
- TPG Capital - $47 billion
- CVC Capital Partners - $42.2 billion
- Advent International - $40.9 billion
- Bain Capital - $37.7 billion
- Apax Partners - $35.8 billion.
Private Equity Funds
The money raised by these firms are called private equity funds. It usually comes 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.
Prequin, a private equity analyst, divides private equity funds into five major types. All categories except for venture capital have outperformed the S&P 500.
- Distressed - Investors focus on turnarounds of companies in trouble. Not surprisingly, this category has done the best since the 2008 financial crisis.
- Buyout - Investors focus on buying out a company completely. This is the second-best performer.
- Real Estate - Focuses on commercial real estate, such as apartment companies and REITs. This was the third-best performer.
- Fund of Funds - Invests in other private equity funds.
- Venture Capital - Investors, often called "angels", take part ownership of a start-up in return for seed money. These investors hope to sell the company once it becomes profitable. They often provide expertise, direction, and contacts to get the company off the ground. They often fund many companies, knowing that only one will really become successful. However, this one success could more than outweigh all the losses.
Problems Hidden in Private Equity Financing
Private equity firms use cash from their investors to purchase companies. The return on that investment attracts new investors. It's called the internal rate of return, and it 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. They call on investors' cash later 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. As a result, the banks didn't care if the loans were good or not. if they were bad, someone else was stuck with it. 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)