Private Equity Firms Focus on Growing Their Portfolio Companies and Making Alternative Investments

There are myriad companies, both in the U.S. and abroad, that specialize in making private equity investments. Industry leaders include Blackstone Group, Kohlberg Kravis Roberts (KKR), Texas Pacific Group (TPG), Thomas H. Lee Partners and Carlyle Group. Globally, there are thousands of these firms in operation, but most of the money is held by a few top-tier companies.

Generally, these firms pool money from institutions, pension plans and wealthy individuals who are looking to make higher returns on their investments. The fund managers use these pools to acquire controlling interests in companies of all types. Significant amounts of leverage are typically employed so that a combination of debt and equity creates larger potential returns. Such investments are often referred to as “leveraged buyouts” or “LBOs.”

Private equity firms have become more diverse in the types of investments they are willing to make. For example, many have been making private placements in public companies (which are referred to as PIPEs) and higher-risk “bridge” loans to help firms that need capital today in anticipation of future funding events.

The largest private equity management firms often raise $10 billion or more to manage in a single new pool, and each firm may have several such pools that were raised in succession over a number of years. Management fees are extremely lucrative, typically 1% to 2% of assets for annual management, plus 1% of the value of completed deals, fees for various services, and up to 20% of total net profits. In order to justify these fees, investors must be offered the potential of enormous profits.

Eventually, private equity investors earn a return on capital when the acquired firms have an IPO or are sold off. An example is the IPO of the Hilton Hotels firm, formerly owned by private equity investors. Additional returns are often earned when managers do a complete financial restructuring of an acquired firm. This might involve loading the acquired company up with significant amounts of debt, and then using all or most of that debt to pay a huge dividend to the private equity shareholders. Then, the heavily indebted company might have an IPO, selling its stock to the public, hopefully creating an even higher return for the private equity shareholders.

Average annual returns on invested capital can be very high. In good years, successful private equity funds have often returned annual profits of 30% or more to investors.

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