Private Equity 101

For those of you not familiar with private equity, here’s some background to help you understand the KKR post.

Private Equity is essentially that: equity investments which are not publicly traded. Equity investments are stocks, which represent shares of ownership, and debt investments are bonds, which represent lending. Over the past 20-30 years, private equity companies have multiplied. Generally large institutions invest in private equity firms. Other investors may be accredited investors, which are high-net-worth individuals who have met certain requirements for participating in alternative, higher-risk investments.

The Private Equity firms take the large investments (called “raising funds”) and make large equity placements in companies. Sometimes the placement is large enough so that the company is delisted, or taken off the public exchange and now privately owned either partially or in full by the private equity firm. Private equity firms usually prefer to take a majority stake so that they effectively own the company, and then put in their hand-picked management team.

Why invest in private equity? The institutions and accredited investors invest in private equity firms because they are looking for better returns than they can find elsewhere. They are sophisticated investors who understand the risks of alternative placements, and are under pressure to provide returns for their own investors. The institutions are usually pension funds, university endowments, insurance companies, banks and hedge funds to name a few.

Regulation D (Reg D) is an SEC regulation which means smaller privately owned companies can sell equity or debt on the private market without having to go through a public offering. Companies which sell securities must be either registered with the SEC or meet an exemption, and Reg D is one of them. Why avoid a public offering, also known as “going public”? Because of the enormous cost, hassle and ongoing compliance requirements of publicly owned companies. You can read my earlier post on Sarbanes-Oxley to see that a lot of smaller publicly owned companies – and even the largest ones – are not happy with the ongoing requirements of Sarbanes-Oxley.

For our last question, why the growth of private equity since the 70s? As with most developments, changed regulation led to changes in the marketplace. In 1974, ERISA was passed. ERISA is a comprehensive law regulating employee benefit plans and retirement plans. ERISA allowed corporate pension funds to invest in more risky securities, thus creating a supply of funds for investing and a demand for returns. In 1981, the Reagan tax changes went into effect, which lowered the capital gains tax and created new demand for investing in securities. Late in the 80s things slowed in the private equity market with the fall of Drexel Burnham and the S&L debacle. But of course, everything picks up again, and so it did in the 90s.

There was a temporary slowdown from the bursting of the internet bubble in 2000-2001 and then things rose again starting in 2002. Activity in Europe loosened up, providing even more supply of funds for investing and greater demand for alternative investments. The trend over time has gone from short-term benefits to long-term. In the 2000s many private equity firms hold their companies, put in a management team and plan for the long-term. This takes us up to the credit crunch starting in 2007 which put the brakes on debt financing and brings us to the following post on KKR.