A question that is often wondered: what is private equity? For something so prevalent in all of our daily lives, the majority of the public seem to know almost nothing about it. Imagine you and a group of friends pool your money together to buy a run-down house in a great neighbourhood. Instead of just living in it, you completely remodel the kitchen, fix the roof, and upgrade the landscaping. A few years later, you sell that house for a massive profit. At its core, that is exactly what private equity does, but instead of houses, they do it with entire corporations. Private equity firms pool money from large institutional investors, like pension funds, university endowments, and wealthy individuals, to buy companies that are not traded on public stock exchanges. The ultimate goal is to take over a business, make it much more valuable over a five-to-seven-year period, and sell it to a new buyer or launch it on the public stock market for a big payday. Today, major players like Blackstone manage over $1.3 trillion in assets, showing just how massive this industry has become.
Private equity firms do not use a one-size-fits-all approach, and they generally rely on a handful of main game plans depending on the company they are targeting. The most famous strategy is the leveraged buyout, where a firm buys a mature, established company using a small amount of their own cash and a massive amount of borrowed money, debt which they then pin onto the purchased company. They then use the company's own revenues to pay off that debt while fixing the business, which is exactly what happened when Blackstone and Vista Equity Partners teamed up to take the software company Smartsheet private in a deal valued at roughly $8.4 billion. Venture capital is another specialised slice of private equity that focuses on the very beginning of a company's life by investing in tiny, unproven startups with high growth potential, in the hopes that their investment skyrockets once the company begins to expand.
The financial returns generated by these strategies can be staggering, and historically, global private equity has outperformed the public stock market by about 5% per year over the last quarter-century. Over a 25-year horizon, private equity funds have averaged around 13.1% in annual returns compared to just 8.6% for the S&P 500. The main secret behind such success is the hands-on ownership model private equity firms employ. Unlike a public investor who cannot call a CEO to demand changes, a private equity firm takes total control of a business to cut unnecessary expenses, hire better executives, update outdated technology, and rewrite the strategy. It is because of this ownership model that private equity has garnered such a bad reputation within recent decades, particularly due to the often ruthless cost-cutting these firms demand. The most notorious example of this is the downfall of Toys "R" Us. In 2005, a consortium of private equity firms bought the highly profitable toy retailer in a massive $6.6 billion leveraged buyout, loading the company with over $5 billion in debt. Instead of investing in digital upgrades to compete with Amazon, the retailer was forced to spend over $300 million a year just to pay off the interest on that debt. The weight of this financial burden destroyed growth and inevitably dragged the company into bankruptcy, forcing the closure of all 700 US stores and completely wiping out 100% of its workforce, leaving over 30,000 employees abruptly jobless with zero severance pay.
You may think this catastrophic corporate collapse was an unintended failure of private equity. However, the unique structure of these firms ensures that the managers and companies involved remain incredibly rich even when the underlying business is completely destroyed. This bulletproof profit model relies on aggressive fee extraction throughout the life of the investment. Even as Toys "R" Us was drowning in debt and heading toward bankruptcy, the private equity owners extracted over $470 million in management fees, advisory costs, and interest payments directly from the struggling retailer.
Furthermore, the structure of these investment funds heavily insulates the managers from personal financial ruin, because the billions of dollars used to buy the company is legally the liability of the acquired business, not of the private equity firm or its executives. If the business goes bankrupt and defaults on its loans, the lenders take the loss while the private equity managers walk away with millions in accumulated management and advisory fees.