Q What is private equity?

A Private equity describes a group of companies that raises funds from investors, typically pension funds, and uses the money exclusively to buy companies, which they run privately, out of the glare of the public stock markets. This practice of holding unlisted, private shares, or equity, is what gives the financiers their name. Average fund sizes used to be about $2 billion (£1 billion), but now the megafunds top $15 billion to $20 billion, so they have a lot of firepower.

Q What is the difference between private equity and venture capital?

A Venture capital firms, like private equity, also raise funds to buy companies. The main difference is that venture capital firms typically invest in young, start-up firms or in small, growing companies. Their investments are much smaller than typical private equity deals. An average venture capital investment might be £200,000, while a typical private equity cheque might be £500 million.

Q Where did private equity come from?

A Private equity started in the United States in the early 1980s as global banks such as Citibank saw a chance to set up private funds to acquire companies. Over time, the banks ran into difficulties as their private equity units were competing with their big clients. Many of the banks spun off their investment divisions into separate companies. CVC was spun off from Citigroup in Europe, Permira was spun off from Schroders and BC Partners from Barings. At the same time, independent private equity firms, such as Blackstone and Kohlberg Kravis Roberts, were founded in the United States by senior figures such as Stephen Schwarzman and Henry Kravis, from inside investment banks. As well as making acquisitions, many also have other divisions, such as corporate advisory or restructuring.

Q How do private equity firms fund their purchases?

A One of the biggest differences between private equity companies and public companies is that private equity firms use lots of debt when making acquisitions. Typically, a buyout, as the acquisitions are known, will include about one third of the private equity firm’s own cash and two thirds debt borrowed from the banks. Often, the partners in a private equity company will put in some of their own cash as part of the equity cheque, providing individuals with an ever bigger return if things go well.

Q What happens to the debt when the company is taken over?

A Once a private equity firm has made an acquisition, it places the borrowings on to the balance sheet of the acquired company. This means that it is the firm being bought, not the private equity company itself, that is liable to pay the debts back from its cashflows. In addition, the portion of equity that the private equity firm does contribute is often structured as a so-called “shareholder loan” to the target company, and, therefore, is treated as debt, which is tax deductable.

Q What are recapitalisations?

A Once a private equity firm has owned a company for six months or a year, it will refinance all the debt and use that opportunity to pull out some cash to pay back to its investors. Think of this like remortgaging a house to borrow some cash to buy a car. In that case, you end up paying a bigger mortgage; in private equity’s case, it is the acquired company that has the bigger mortgage, albeit sometimes on cheaper terms.

Q What does private equity do once it owns the business?

A As soon as it buys a company, a private equity firm will enact a 100-day plan, where it makes a series of often harsh changes to improve the business. That can involve bringing in new management, cutting jobs, stream-lining supplier contracts and getting rid of loss-making divisions. After the initial restructuring, private equity firms will invest heavily in the business to make it grow, often making other acquisitions, expanding the business overseas or adding new products and services.

Q How do they make money?

A A variety of ways. Private equity firms are run as partnerships whereby a small number of individuals own the firm. All partners earn a salary and a bonus. In addition, the group takes a management fee, about 1.5 to 2 per cent, from investors to manage their money on their behalf. Then they take a “carry”, which amounts to 20 per cent of the profits after investors have been paid back their money, with interest and after certain performance hurdles. The profits are then shared between the partners. Obviously, the harder the private equity firm drives the business, the more it makes from a sale or flotation three to five years down the line when they come to exit.

Q Do they pay tax?

A Yes, private equity partners pay normal income tax on their salaries and bonus. The problem is that their salary makes up such a small proportion of their overall compensation package. Most of it comes from the “carry”, which is taxed as a capital gain on the investment and therefore is subject to taper relief if the individual or fund keeps its money invested for more than two years. Given the number of acquisitions that private equity firms make, the stream of profits from “carry” quickly multiplies into the tens of millions of dollars.

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