Article Summary: What Private Equity Firms Are and How They Operate by Chris Morran and Daniel Petty

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The private equity model is unique in capital markets: Investors directly acquire a business; reorganize its operations, financials and management; and then exit the company through a sale for more than the original purchase price. While this framework profitably serves private equity investors, troubling aspects lurk behind the scenes. Investigative journalists Chris Morran and Daniel Petty delve into the sector to explore how – and if – private equity creates value for companies and their stakeholders. Executives, students and investors will find this an informative report.

Take-Aways

• Private equity has increased its market position as an asset manager and acquirer of businesses.
• Some view private equity as a successful form of capitalism, while others note that it leads to long-term wealth destruction and stakeholder dissatisfaction.
• The top financial driver for private equity is its use of debt to finance acquisitions.

Summary

Private equity has increased its market position as an asset manager and acquirer of businesses.

With $6.5 trillion under management in the United States alone in 2020, private equity (PE) continues to account for an increasing share of financial assets. PE funds are unique investment vehicles that deploy capital directly into businesses through acquisitions. PE managers receive capital from institutional and accredited investors, and then put that money to work by purchasing companies directly, streamlining their operations and subsequently selling them for a higher price.

“Private equity is seemingly inescapable. From housing to hospitals and fisheries to fast food, equity investors have acquired a host of businesses in recent decades.”

PE operates across diverse industries; for example, the number of health care PE deals tripled from 2009 to 2016. In 2021, PE financed approximately 50% of the US multifamily housing stock owned by the 35 largest property owners. Bain Capital, Blackstone and KKR are prominent PE firms.

Some view private equity as a successful form of capitalism, while others note that it leads to long-term wealth destruction and stakeholder dissatisfaction.

Supporters argue that PE firms provide capital to companies that might otherwise not have access to it. And PE firms seek to deliver higher returns than other investments, which institutional investors such as pension funds demand. Those opposing PE point to the damaging effects of steep cost-cutting on labor and enterprise value. The PE model delivers profits, critics say, but the returns often come at the expense of a business’s employees, customers and financial condition.

“Large private equity firms…don’t ultimately create wealth but tend to extract it from companies through the use of leverage and other means.”

PE principals earn their returns under the “2 and 20” model, which consists of a 2% administrative fee based on the asset holdings of the acquired business, and 20% of any profits from the eventual sale. The gains are also taxed at a lower US federal tax rate under the “carried interest” provision.

The top financial driver for private equity is its use of debt to finance acquisitions.

Debt has always been a staple ingredient in PE operations. At the peak of the leveraged-buyout boom in the 1980s, “debt-to-enterprise value ratios” often reached 90%. Today, that has declined to 60%. Debt enhances profitability because interest payments are tax deductible. But leverage can have deleterious impacts on an acquired business: For example, in 2005, PE giants KKR and Bain Capital saddled Toys R Us with billions in debt, even as the company was struggling in the highly competitive online marketplace.

“One of the more criticized aspects of leveraged buyouts is that the debt used to finance the acquisition doesn’t belong to the equity firm or fund. Rather, it belongs to the newly acquired company — and it can become an anchor that drags that business down.”

Without regulatory or tax changes, PE will likely continue to expand its presence in the capital markets. In the process, however, some of the largest PE firms are becoming the lumbering, inefficient businesses they seek to streamline.

About the Authors

Chris Morran is an audience editor at ProPublica, where Daniel Petty is the director of audience strategy.