Private equity ownership is behind many of the largest and most visible companies operating today. Anyone interested in growing or selling a valuable business might attract the interest of a private equity firm.
Selling your business to a private equity (PE) firm can be slightly different than selling to an individual or another company; it’s natural for business owners to want to ensure the best outcome for their employees and to prolong their legacy, so it’s important to understand the implications of such a sale. Let’s cover private equity basics by discussing what private equity means, what PE firms do, and what to expect as an employee at a private equity-owned business.
What Do Private Equity Firms Do?
Private equity firms invest in companies and provide them with capital. These investors also pursue strategies to expand the business, streamline operations, and improve the bottom line before eventually selling them for a profit.
In many cases, PE investors will target companies that have growth potential but are financially constrained or risk averse. Financial investment, experience, and resources allow the company to accomplish its near-term financial goals and successfully grow into its potential.
Private equity investors typically purchase a controlling stake in a business. This allows them to take an active role in reorganizing the business as needed to reduce expenses and streamline operations.
Types of Private Equity Firms
There are three broad categories of private equity investors: angel investors, venture capital firms, and private equity firms.
● Angel investors make relatively small investments in early stage businesses and startups. They don’t usually take a controlling stake in the company, preferring to let the business grow on its own. These businesses may not have a proven profit model or any revenue at all yet.
● Venture capital firms also invest in young businesses and startups, but later in the life cycle than angel investors do. Venture capital investment typically favors businesses that lack the resources to scale up a proven profit model.
● Private equity firms, also known as private equity advisory firms, focus on mature businesses that are already generating a profit. It is common for private equity firms to buy a controlling stake in the business, but minority positions are also taken in certain cases.
How Private Equity Creates Value
Most PE firms exclusively invest in companies positioned within industries in which they have operational knowledge. Various types of private equity firms leverage a combination of capital resources and years of experience to create ideal conditions for company growth.
The process of taking a company and turning it into a successful, well-established business can take years. The best private equity firms employ experts who know exactly how to achieve these results for the companies in their portfolios.
Often, this means gaining efficiencies through cost control, boosting profits through price improvement, and identifying opportunities to capture more of the market. This may also include a focus on sustainability, with many PE funds now considering environmental, social, and governance (ESG) risk factors as part of their due diligence and value creation plans.
How Do Private Equity Firms Make Money?
Private equity firms invest capital and expertise into mature businesses in traditional industries in exchange for an ownership stake—also called equity—in these companies. Their goal is to increase the value of a business and eventually sell it for a profit.
To create a large amount of capital available for investment, the private equity firm pools capital from investors together and forms a private equity fund. Once it meets a specific fundraising threshold, it closes the fund and begins investing that money into promising companies that fit its defined niche or strategy.
A private equity firm also earns fees through the collection of carried interest. This is the payment fund managers receive after completing a successful investment and achieving a return to the investors above a predetermined threshold. Investors in the fund look to private equity fund managers to make smart, sound investments that grow over time and produce positive returns for everyone.
What Happens to Employees When a Private Equity Firm Buys a Company?
Business owners and managers want the best for their employees after a PE firm acquires their company. Private equity investors’ focus on increasing company profitability often makes employees unnecessarily anxious about job security.
However, private equity firms generally find the value that attracted them to a business lies largely within its workforce. Private equity firms don’t “win” by driving companies into bankruptcy or firing all the employees. They earn money by guiding companies toward greater success—and no company can succeed without its employees.
The best private equity firms increase company value by leveraging employee talent and improving the productivity of the workforce. They also help to reshape the company culture by providing direction and introducing positive changes to policies and leadership that align with the shared company vision.
When reputable private equity firms invest in companies, they make a pledge to turn that company into a more sustainable, growth-oriented organization. Therefore, a more successful company is a benefit to employees as well as owners because growth unlocks opportunities.
Private Equity Terms To Know
To better understand the private equity basics and key concepts, it is important to review some commonly used phrases and terminology.
● Private equity: A form of investment in companies that are not publicly traded.
● Private equity fund: An investment structure with multiple investors who pool their capital to invest in various companies.
● Limited partner: An investor in a private equity fund.
● General partner: The manager of a private equity fund who selects investments and plays a hands-on leadership role with purchased businesses.
● Controlling stake: A majority ownership interest in a business.
● Minority stake: A non-controlling interest in a business of less than 50 percent.
● Buyout: The term used to describe the acquisition of a majority stake in a business.
● Business sale confidentiality agreement (or non-disclosure agreement): A contract where all parties agree to not share confidential information.
● Letter of intent (or term sheet): A non-binding agreement that outlines the basic terms of a transaction between a buyer and seller.
● Business purchase agreement: The contract that finalizes and documents the sale of a business.
● Carried interest: The share of profits paid to the general partner of a private equity fund as compensation.
● Preferred return (or hurdle rate): The minimum return a fund must provide to investors before the general partner can earn carried interest.
● Committed capital: The total amount of capital that investors have agreed to contribute to a PE fund.
● Drawdown (or capital call): A request of a portion of the committed capital from the limited partners of the private equity fund.