What is Private Equity & Why does it Matter?

If you asked a Private Equity professional what they do, they would tell you that they create jobs, supports the economy and empowers retirement accounts for millions of Americans…

But what if you asked someone who doesn’t have financial stake in PE? Might they express concerns over the entire industry and how it might be largely responsible for the slow decay of small businesses and quality products & services everywhere? Might they say that PE is responsible for the most manipulative business practices in the country? As it turns out, many say that.

So let’s take a deep dive into the world of Private Equity, what they do, what they do behind the scenes without talking about it, and it’s externalities for everyday people.

What is Private Equity?
Private Equity is essentially a type of investment structure where firms purchase significant stakes - often full ownership - of companies with the aim of improving their financial performance and increasing their value over a set time period.

Contrast this with public equity, which is all about companies that are listed on stock exchanges, where shares can be bought and sold by anyone.

Private Equity is one of the most impactful & powerful industries in the USA, but mostly operates under the radar.

When it comes to private companies, they need to raise money elsewhere. Why? Because they aren’t listed on stock exchanges. This means they can’t sell shares to the public the way public companies do so they they instead rely on other sources like:

• Private Equity Firms: Private companies can partner with private equity firms that provide funding in exchange for ownership stakes. These firms often bring both capital and “strategic guidance” to help the company grow.

• Venture Capital: For startups and high-growth companies, venture capital (a type of private equity) is a common source. Venture capitalists invest in return for equity, usually in the early stages when the company has high growth potential but also high risk.

• Angel Investors: These are individuals with significant wealth who invest in private companies, especially startups, to provide the funding they need to get off the ground.

• Debt Financing: Private companies can also take out loans or issue private debt, which allows them to raise money without giving up ownership, although it does require paying interest.

So why would a company look to Private Equity over those other options (VC, Angel Investors & Deb Financing)?
Because Private Equity offers more intensive management, more industry connections, and is generally more attractive for companies willing to give up stake in the company instead of paying back interest on debt financing. Simply put, the idea is that PE provides more “skin in the game” for companies in which they take ownership.

Additionally, VC and Angel Investors generally focus on early-stage, high-growth startups whereas PE generally targets more mature companies that have some stability.

Some of the biggest Private Equity firms are:

• Blackstone

• Apollo

• Carlyle Group

• KKR

These firms monitor consumer behavior to identify sectors showing increasing demand. So for example, if consumers are increasing the amount of money they spend on fitness then Private Equity firms might target fitness-related companies with the aim of consolidating & scaling them to capture more demand within the sector. Basically, PE is involved almost anytime money is spent.

But How Does Private Equity ACTUALLY Make Their Money (how do they become so lucrative)?

1. Management Fees (typically 2% per year)

2. Performance Fees, AKA Carried Interest (typically 20% of annual profits)

Even if their investments don’t perform as expected, firms consistently collect earnings from management fees. So for eg, a fund managing a billion dollars would typically earn 20 million per year just from these fees. However, most of a firm’s outsized earnings come from performance fees, which represent about 20% of the profits generated from the fund’s successful investments.

When does Private Equity show it’s teeth?
Almost anytime someone spends money. How? Because Private Equity firms generally invest in every step of the supply chain, which means they’re often indirectly connected to almost any given purchase…

Let’s say you go to the grocery store and buy a loaf of bread… While it may not seem obvious, Private Equity is often involved:

• Many grocery stores are owned or backed in part by PE firms. Any purchase at such a store will benefit the PE firm.

• The brands that produce the bread (or their parent companies) are often backed by PE, so if a firm invests in a brand that produces bread then they are likely to try to expand the market reach of that brand or by streamlining the production.

• PE also invests in the distribution companies & ingredient suppliers that provide stores with that bread

So if PE has its hands in everything, why don’t we hear about it?

1. Lack of Transparency: PE firms and their portfolio companies don’t have the same reporting requirements that public companies must adhere to. They aren’t required to disclose their financials or operational decisions, so their actions stay relatively hidden from public view. So unlike public companies that have to report every dollar they make and lose, private equity firms get to work in the shadows. They don’t answer to regular folks, and they certainly don’t want some blogger sniffing around asking, “What do you actually do here?”

2. Complexity and Niche Focus: PE operates in a complex financial world, and its details can be hard to understand or less intuitive to the general public (that’s why I’m writing this!). This complexity can make it harder for mainstream media to cover in a way that resonates with their target demographics. To put it brashly, PE thrives on jargon; leveraged buyouts, debt restructuring, EBITDA multiples - all designed to make you tune out. So unless you’re the kind of person who thinks watching paint dry is a thrilling Saturday night, this stuff is confusing, and they know it.

3. Focus on Private Markets: Since PE deals mostly involve wealthy investors and large institutions rather than everyday investors, there’s less direct impact on most people’s lives, at least on the surface. For eg, a PE firm might buy a retail chain, but customers may not realize there’s been a change in ownership until they experience cost-cutting measures. In laymen’s terms, it’s the ‘not my problem’ effect. PE deals with big fish and deep pockets, not regular people. They’re buying up retail chains, closing mom-and-pop shops, and jacking up healthcare costs, but you’re just buying toothpaste, so it feels like it doesn’t affect you.

4. Media Spotlight on More Visible Players: High-profile sectors like tech, entertainment, and publicly traded companies often dominate financial news, overshadowing private equity (see the 2nd point above). PE’s operations are usually discussed more in niche financial publications rather than mainstream news. Regular people don’t have time for that.

5. Connections to Influence: Private equity firms often have close ties to influential business and political networks. This influence can shape the narratives and policies around PE’s role in the economy, sometimes limiting critical examination in public discussions. So these firms aren’t just in business with different elite institutions, they’re in bed with them! These people know everyone, from senators to socialites. They’re at the charity galas, they’re hanging out on private islands with models & superstars, they’re in on the boards of nonprofits, and on the guest list of any political event worth its weight in caviar. With that kind of clout, the conversation stays exactly where they want it: out of your newsfeed.

Private equity is like the secret VIP club of finance, where billionaires, boardroom powerbrokers, and the slickest money managers make moves nobody else sees. So to sum up why people don’t talk about it, it’s because private equity is a world shrouded in mystery and cocktail napkin deals, far from the prying eyes of the public.

Ok, so how does PE acquire companies?
It’s kind of similar to flipping houses with more moving parts, where they manage companies instead of real estate. One of the most favorable types of acquisitions for PE - which they are notorious for - are called “Leveraged Buyouts”:

How Does an LBO work and Why does it matter?
The way an LBO works is when a PE firm buys assets using borrowed cash that they pay back with interest, or with a mix of borrowed cash and their own money (equity). The acquired company’s assets and future cash flow are used as collateral for the loan, which means that the company itself is responsible for repaying the debt, NOT the PE firm. Using debt increases potential ROI because if the company’s value increases, the PE firm can earn more because it initially invested less of its own money.

By putting only a portion of the purchase price down and using debt for the rest, the PE firm is able to spread its capital across multiple investments rather than tying it all up in one.

The PE firm then restructures the company in order to make it more profitable. This can mean cutting costs, bridging efficiency gaps, or sometimes selling off parts of the business that aren’t core to its growth strategy.

Typically, LBOs involve a detailed exit strategy, where the PE firm aims to sell the company in 5–7 years, either through an IPO, a sale to another company, or - wait for it -a sale to another private equity firm.

So Why the Heck do Companies Agree to LBOs?
For family-owned businesses or public companies with undervalued stock, an LBO can provide a path to restructure privately and with new strategic direction. The conventional idea here is that an LBO lets you get out of the public eye, out of the family drama, and into something with clearer & greater potential.

It’s like bringing in the mob but in a tailored suit with a roadmap to profitability, where they take you private, get you out of the Wall Street pressure cooker, and suddenly you can make moves without the board breathing down your neck.

So what’s the problem with this type of acquisition?
Critics of PE say that leveraged buyouts result in debt that the companies must pay back over too short of a time horizon, causing high debt load & a short runway for landing a profit. These are 2 key issues that often cause the companies to make cuts in essential areas like staffing and R&D in order to free up cash for debt payments, as well as increased focus on short-term gains from aggressive cost-cutting which may degrade long-term growth and overall quality.

Where does that cash used to pursue a Leveraged Buyout (LBO) come from?

1. Pension Funds (retirement funds of everyday people)

2. Endowments (large savings & investments set up by universities which are comprised by donations from alumni, foundations, and other supporters)

3. Large institutional investors (elite money piles from families enjoying generational wealth)

These sources of capital are the financial underpinning for leveraged buyouts, allowing PE firms to acquire companies with a mix of equity and borrowed funds. The concern here is that the LBOs come with significant risks that can negatively impact retirees, employees, and the economy as a whole if things go south.

This is because pension funds and endowments are not directly involved in the day-to-day operations of the companies they invest in, so it can result in a lack of accountability for the actions of PE firms. This “out of sight, out of mind” bit may allow for practices that prioritize returns over ethical considerations such as fair treatment of employees, environmental impact, or community welfare.

This lack of oversight & accountability also mean that investors become reluctant to challenge these decisions because their primary interest is their own financial outcome rather than the means by which it is achieved.

Ok, so we’ve gone thru the basics of Private Equity, what its firms do and how they do it - now let’s get to the real kicker…

The Broader Scope of Private Equity Investments
Private Equity doesn’t just buy companies - they buy whatever is lucrative. In the USA, healthcare represents a staggering 17% of the GDP, making it a trillion-dollar industry ripe for investment. Within this sector, there are numerous intermediaries (health insurance companies, pharmacy benefit managers, device manufacturers, billing companies, consultants, 3rd party admins, IT companies, etc) who siphon billions from the healthcare system.

These intermediaries contribute to the complexity of the healthcare system and can influence costs and patient care experiences. It’s also what is so darn attractive to PE. (Can anyone smell competing interests?)

While those in PE will suggest that their firms ownership of healthcare practices allows doctors to fully focus on patient care rather than the backend business technicals, those who don’t work in PE will bring up instances of surprise billings, higher costs, layoffs, and overprescribing medications - all of which can reasonably be attributed due to being owned by profit-mongering institutions without oversight that would otherwise keep them in check and within the scope of ethical concern.

So what is contributing to PE’s influence & scale?

1. Low interest rates that gave PE a cheap source of debt - this empowers their ability to pursue those leveraged buyouts we covered earlier.

2. Lower regulation from the Securities & Exchanges Commission (SEC) in private markets

3. Lobbying (they’re real good at this)

Lawyers working at the Securities & Exchanges Commission (SEC) are generally allured to the prospect of landing a job on wall street that triples their current salary. The thing is, they only get hired on wall street and thus triple their salary if they play nice with PE. If they prosecute PE firms, that isn’t exactly what they consider “playing nice”. Fun Fact: JPOW used to be a partner at one of the elite PE firms. It’s a dynamic that raises important questions about accountability in a system where a few entities hold so much influence.

These regulatory roadblocks render the financial landscape of private equity unclear, even for investors directly involved in the fund. While firms are required to publish semi-annual reports detailing their expenses, these documents often lack comprehensive disclosure, leaving much of the investment process shrouded in secrecy. The shrouded nature of the PE industry allows firms to conceal most of their fees & returns. Warren Buffett has famously pointed out that the returns presented by PE funds are often calculated in ways he considers less than forthright, and that firms have a tendency to bend the truth in order to procure capital.

In fact, oftentimes (if not every single time), these returns are calculated by people hired by the firms themselves, like a student grading their best friends quiz while the teacher is busy elsewhere. Simply put, there’s hardly any outside regulators coming in to vet the firm’s processes.

How do they get away with such little regulation? Why can’t other industries pull of this furtive financial fabrication?
In 2023 the SEC finally decided to step up its game and rolled out some new rules for PE firms & hedge funds; namely fee disclosures. So does that mean everything is dandy in the world of economic finance? Hard no. Why hard no? Because The Managed Funds Association - the club representing hedge funds and PE firms - didn’t take too kindly to this. They’ve teamed up with the American Investment Council to sue the SEC. Yup, nothing screams “trust us” like a bunch of billionaires throwing a tantrum over transparency.

Currently this is all unfolding in court, with the Fifth Circuit Court of Appeals weighing in on whether the SEC can actually tell these firms what to do. It’s like watching a reality show where the contestants are hedge fund managers trying to outsmart the regulators.

The reason few other industries can pull this off is because, well, it takes a whole lot of cash to grease a whole lot of the hands that bring down the gavel.