Island Investing: Private Equity

Q. What is a private equity fund?

A. Private equity is the modern name given to firms that in the 1980s and early 90s used to be called leveraged buyout funds, or LBOs. After a slew of companies bought by these funds went bankrupt, however, these firms adopted a more benign sounding label. Don’t let that fool you. Private equity is an intense, often brutal world.

The most well-known private equity firms include companies like the Carlyle Group, KKR, and the Blackstone Group, while other firms like Goldman Sachs have private equity divisions. Private equity funds usually acquire whole companies or divisions of companies with the intent to fix them. Later, the fixed company will be resold, either to another company or to the public through an initial public offering.

In order to come up with the cash to buy a public company, a private equity fund will borrow a ton of money. Then it will use the cash flow created by the acquired company to pay the interest on that debt it just took on. Because the acquired company will have so much debt, its bonds are typically rated as “junk.”

Private equity funds flourished a few years ago due primarily to extremely low interest rates. Because borrowing money was ridiculously easy, private equity funds raised billions upon billions of dollars and bought up many companies, and even an English soccer team. 2006 saw a staggering $800 billion worth of private equity deals.

Ah, good times. That party ended, though, with the recent financial crisis and the ensuing Great Recession. Many companies bought by private equity firms and loaded up with debt now face some serious challenges in meeting their debt payments.

Private equity firms would like you to believe that by buying public companies and taking them “private,” they enable those companies to take the steps necessary to improve their operating performance without the hassles and glare of being in the public spotlight. There may be some truth to that, but as usual when it comes to Wall Street, take it with plenty of grains of salt.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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3 Responses to Island Investing: Private Equity

  1. Kirk Kinder says:

    The only thing keeping the current private equity deals from completely imploding is the recent risk rally. Junk bonds have done well, and junk companies have been able to either refinance or raise new capital in this risk taking environment. If we don’t get a very robust economic recovery, then these companies will be faced with a difficult situation: poor company performance in a reduced risk environment. I am betting on more defaults in this area and a tough slug ahead for private equity.

    • Cale Cale says:

      A good indicator of the market top: when private equity firm Blackstone Group went public in 2007 and founder Schwarzman netted $800 million. Seems a bit ironic to justify taking other companies private to re-tool them out of the spotlight…and then go public yourself, no?

  2. Kirk Kinder says:

    Ironic…Not if you want to raise a ton of cash quick and then dump your shares on some poor sucker…it is brilliant.