Investors

What is private equity?

April 28, 2023
The Carta Team

Private equity is an alternative asset class with investors that raise money from institutional investors and then use that capital to purchase equity in companies with the hope of selling the equity or the whole company at a profit years later. 

What is a private equity firm?

A traditional private equity firm is an investor that raises private equity funds to acquire a majority stake in companies. These investors are known for using a large amount of borrowed money to fund the purchase, aggressively increasing revenue and margins, then exiting through a private sale or IPO. This is known as the “leveraged buyout” or “LBO” model described below.

More recently, many private equity firms have adopted a growth equity strategy. These investors back late-stage private companies through minority investments, then look to cash in when the startup goes through an IPO or acquisition. For these deals, investors typically use minimal debt or none at all. 

Types of private equity investments

There are five main private equity investment categories: LBO, growth equity, VC, secondaries, and fund of funds.

Leveraged buyout (LBO)

Leveraged buyouts are the most common private equity investment strategy. In an LBO, the private equity firm acquires a majority stake in the company, using equity and a large amount of debt that goes onto the company’s balance sheet. The portfolio company is then responsible for paying back that debt through cash resulting from the operational improvements made during the private equity firm’s ownership tenure. 

Growth equity

PE firms that specialize in growth equity investments do not necessarily acquire a majority stake in the company. Instead, they purchase a minority stake in mature private companies that are growing revenue but are perhaps not yet profitable. Growth equity and late-stage venture capital (VC) are often used interchangeably, but they have several key differences. Growth equity and VC deals differ by investment sizes, revenue goals, target industries, and investment geographies.

Venture capital (VC)

Venture capital is a form of private equity. But private equity firms are not necessarily venture capital firms. Unlike PE firms, VC firms typically purchase minority stakes in startup companies, often in the tech industry. VC fund managers then get a cut of the profits, known as “ carry”—similar to PE, this is often 20% after it hits the hurdle rate laid out in the limited partnership agreement (LPA), which is typically once the LPs have had their full initial investment returned to them. VC firms invest for the long-term, with fund lifecycles often lasting up to 10 years.  

Secondaries

Secondary investments come in many forms, but their basic purpose is to purchase a stake in a private company from another private investor. This is a way to provide liquidity for existing limited partners. Secondaries also give investors the chance to purchase a stake in portfolio companies that are theoretically closer to realizing an exit. The VC secondaries market exploded in size from 2012 to 2021, with the global deal market going from $13 billion to $60 billion.

Fund of funds

Fund of funds is a specific type of secondary investment strategy. Rather than invest in individual companies, fund of funds firms invest in a portfolio of external funds. These can include other PE funds but also may include hedge funds, mutual funds, VC funds and more. This allows LPs in fund of fund firms to be more diversified than other LPs, but the drawback is that they face fees from both the fund of funds firm managing the capital and get charged the fees from the external funds they are backing.  

There are also other forms of private equity, including mezzanine investing, real estate investing and more.

How do private equity firms make money?

Private equity firms earned a reputation for being ruthless profiteers during the 1980s. Their investment style was even lampooned in “Barbarians at the Gate,” a dark comedy based off KKR’s hostile takeover over RJR Nabisco. 

In recent years, PE firms have drawn scrutiny from lawmakers for a series of high-profile bankruptcies from debt-riddled companies they owned, including Toys R Us, Shopko and more. Senator Elizabeth Warren has dubbed PE investors “vulture capitalists.”

But there’s slightly more nuance to PE’s investment strategy. Private equity firms make money through carried interest, management fees, and dividend recaps.

  • Carried interest: This is the profit paid to a fund’s general partners (GPs). Typically, PE  fund managers receive 20% of their portfolio company’s profit after they hit the hurdle rate–the amount that goes back to limited partners (LPs)– described in the LPA. PE fund managers do not receive any of the carried interest profits until their LPs see their capital returned first. Carried interest is taxed as capital gains instead of income. 

  • Management fee: This is the fee that GPs charge their own investors (LPs) to manage their money. Typically, GPs will wait until they are ready to make an investment before calling committed capital, thus limiting the LP’s cost burden and boosting PE firm’s IRR, a time-based formula that represents the money returned to LPs. Management fees are taxed as normal income.

  • Dividend recapitalizations: Dividend recaps are slightly more controversial than simply earning carry or charging LPs to manage their capital. In a dividend recap, a private equity firm essentially pays itself back for their original capital investment by taking out a loan against the portfolio company in which it invested. This allows PE firms to nearly eliminate their downside risk while the portfolio company is tasked with improving operations through either revenue growth or kickbacks. In 2017, lawmakers banned dividend recaps within the first two years of a firm owning a company. 

Private equity vs. venture capital

Private equity is not a form of venture capital, but venture capital is a form of private equity. Both investment strategies collect LP money for long-term investments of up to 10 years. However, there are several differences between private equity, which can also refer to leveraged buyout or growth investing strategies, and venture capital.

Private equity

Venture capital

Type of investment

Majority stake

Minority stake

Investment size

From eight figures to $10B+

Seven- and eight-figure deals (though they can be bigger)

Debt use

Uses large amounts of borrowed money

Not a key part of investment strategy

Stage of company

Invests in growth-stage companies, public companies, and other mature businesses

Invests in startups from Seed Series to Series A and beyond

Industry focus

Invests in every industry

Majority of deals in tech

Management style

Focused on becoming more efficient, profitable

Focused on long-term growth

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