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Ben A. Guill

The Truth About Private Equity

The Truth About Private Equity

A lot has been said recently about private equity. Most of it has been negative. An effort has been made to portray private equity, and thus Mitt Romney, as evil and anti-employee. This short article is intended to set the record straight.

Private equity firms raise their investable funds primarily from public and private pension funds, college endowments and foundations. Therefore most people who have money in pension funds are indirect investors in private equity. This would include millions of teachers, state employees and company employees who have retirement accounts.

Therefore most people who have money in pension funds are indirect investors in private equity. This would include millions of teachers, state employees and company employees who have retirement accounts.

There are many types of private equity. The venture capitalists invest in new technologies, new products and services or in clean energy. Some private equity firms provide mezzanine debt. Others make minority investments in companies that need capital. The traditional private equity firms, however, buy controlling positions in established companies.

The very great majority of private equity dollars goes to acquiring assets or all or part of established companies. Believe it or not, most individuals who have built their companies aren’t stupid or uninformed. There are thousands and thousands of lawyers, bankers, accountants and other financial advisors who help company owners manage their affairs, including selling their companies. When they sell, they usually sell for a fair price.

Private equity firms therefore typically make their investments at full market price. Private equity firms look for investment opportunities in companies with strong management teams or with products and services that have extraordinary growth potential. They also look for underperforming companies that have the ability to do better. Private equity firms hope to make their returns primarily by growing companies. They do not make their returns through the use of debt, even though debt does enhance returns. A bad company with a lot of debt usually gets into a lot of trouble.

When a private equity investment is made, some of the dollars most often go to the owner who takes money off the table and the rest of the money goes into the company for growth. These dollars are used to buy new equipment, to open new manufacturing plants or service facilities or to expand into new markets, domestic and international. The goal of the private equity firm is to grow the company so it will be worth a lot more in three to seven years when it can be sold again.

Are some facilities shut down during private equity ownership and are some employees laid off? The answer is often yes, as the private equity firm and management constantly work together to make companies more efficient and more valuable. But there are also many new facilities opened, and there are new employees hired. Remember this: most of the returns generated for private equity come from making companies bigger and better and more attractive to a subsequent buyer or to the public markets. Private equity is a very important source of capital to private and public companies. Investments are most often illiquid, and risk is high. Therefore expected rates of return are high. The hopes for these high returns should and will continue to attract capital from friends or family members, or the largest of the multi-billion dollar funds. Companies need this capital to grow.

That the Obama administration would try to make an issue of Governor Romney’s role at Bain Capital is cynical politics at best. Mitt Romney deserves better, Bain Capital deserves better, and so too, for that matter, do the American people.

  • Tom Keene

    The most important feature of private equity (speaking as a practitioner), is that the entire business model is based on paying ourselves last. Businesses we invest in deliver products to customers, employees get their paychecks, suppliers get their collections, auditors get their fees, insurance companies get their premiums, banks get their debt serviced, and after — and only after — investors get their return (typically after a long lag from the point of investment) do the people who deploy capital into firms on behalf of their investors get paid. Is there an investment model where investors are MORE motivated to ensure everyone further up the financial food chain get compensated and rewarded? Doubt it.

    • http://www.opineneedles.com Opine Needles

      Thanks for the comment Tom. Of course, you are absolutely right!

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  • Richard Colt

    Spot on. Thanks Ben.

    • http://www.opineneedles.com Opine Needles

      I'll pass your note on to Ben. Thanks Richard

  • http://twitter.com/FairTaxNancy Nancy

    Thank you! Well done! I understood it and I’m not even a member of the investor class.