What is Private Equity: The Right Amount of Debt | A Simple Model (2024)

FAQs

What is Private Equity: The Right Amount of Debt | A Simple Model? ›

Most concisely, private equity is the business of acquiring assets with a combination of debt and equity. It is sufficiently simple in theory to be frequently compared to the process of taking out a mortgage to buy a home, but intentionally obfuscated in practice to communicate a mastery of complex financial science.

Private equity (PE) describes investments that represent an equity interest in a privately held company. Any business that is not a public company is part of the substantial private company universe, which includes millions of US businesses compared with the few thousand that are public companies.

What Is Private Equity (PE) And How Does It Work? Definition of Private Equity: Private equity firms raise capital from outside investors, called Limited Partners (LP), and then use this capital to buy companies, operate and improve them, and then sell them to realize a return on their investment.

A company is bought out by a private equity firm, and the purchase is financed through debt, which is collateralized by the target's operations and assets. The PE firm buys the target company with funds from using the target as a sort of collateral.

Private equity modeling has many practical applications. PE companies and VC firms use these models to assess a business's viability, helping them identify the key risks of a potential investment. They also can evaluate the impact of different management decisions and estimate potential returns for investors.

For example, a fund of funds firm will invest in a real estate private equity firm, a venture capital company, or a leveraged buyout fund. Professional investors manage the fund and charge a management fee. With this type of fund, investors achieve the benefit of diversification.

Private equity funds are illiquid and are risky because of their high use of debt; furthermore, once investors have turned their money over to the fund, they have no say in how it's managed. In compensation for these terms, investors should expect a high rate of return.

When a private equity firm recapitalizes a company, they often use debt financing to finance part of the acquisition price – we have written about this here. In addition, private equity firms often ask owners of the companies they buy to “roll over” or reinvest part of their equity into the new company going forward.

Private equity fund structure

The fund is managed by a private equity firm that serves as the 'General Partner' of the fund. By contributing capital, investors become 'Limited Partners' of the fund. As such, the fund is structured as a 'Limited Partnership'.

1 Funds that rely on an Accredited Investor standard generally require a minimum net worth of $1 million for an individual (excluding primary residence), and $5 million for an entity. for an individual, and $25 million for an entity.

What is private debt and example? ›

Private Debt Explained

Private debt is money that individuals, businesses, or other non-government entities borrow. It includes loans from banks, company bonds, and other forms of lending such as lines of credit and mortgages.

When a privately-held company takes out a business loan, or when an entrepreneur borrows money from a family member, those are both examples of private debt. Private debt can take many forms, but commonly take the form of credit card debt, corporate bonds, business loans, or personal loans.

Private debt definition

Private debt – also known as private credit – is a private capital strategy in which investment managers and institutions invest by making private, non-bank loans to companies.

Investment bankers make money by advising companies, structuring sales, raising capital, and taking a percentage fee on each transaction. By contrast, private equity firms make money by exiting their investments. They try to sell the companies at a much higher price than what they paid for them.

Private equity funds are generally backed by investments from large institutional investors: pension funds, sovereign wealth funds, endowments and very wealthy individuals. Private equity firms manage these funds, using both investors' contributions and borrowed money.

Private equity firms invest the money they collect on behalf of the fund's investors, usually by taking controlling stakes in companies. The private equity firm then works with company executives to make the businesses — called portfolio companies — more valuable so they can sell them later at a profit.

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).

Behind the glitz and glamour, “Shark Tank” gives viewers a glimpse into the real world of private equity investment. Every day, private equity firms invest in or entirely buy companies on the promise that their capital infusion will make businesses soar to new heights.

Private equity firms typically invest in private companies and see returns on investment by improving the company's profits. On the other hand, hedge funds use complex investing techniques, like hedging and leveraging, to see returns on investments in the market via securities like stocks, options, and futures.