What is private equity and how does it work? (With benefits)

By Indeed Editorial Team

Published 1 July 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

The term private equity is used a lot in business and finance. As a concept, it's particularly attractive to investors, as the returns are significantly better than those in public equity markets. Consequently, private equity has generated a lot of public interest and learning more about it can help you begin a lucrative business career. In this article, we answer the question 'What is private equity?', explain how it works and list the key benefits of private equity.

What is private equity?

If you're an avid follower of business news, you may have asked the question 'What is private equity?'. As the name suggests, private equity refers to a privately owned or managed enterprise which is not traded publicly, meaning that they're not found on the stock exchange. They're typically funded by wealthy individuals or large corporations that acquire ownership of other privately held companies. Private equities are sometimes run or managed by corporations looking to purchase public businesses and take them off the stock exchange.

There are fewer people involved in private equities compared to a public company. The investors are mostly partners along with the firm that's managing the capital or investment. The private equities model is a 99 and 1% partnership. Investors are often known as limited partners because they hold a majority share and have less liability. In contrast, firms are considered general partners and have full liability. With private equities, it can take years before you see a return on your investment, as its growth is predominantly long-term.

Related:

  • 35 private equity interview questions (plus sample answers)

  • How to become an investment banker

How do private equities work?

Private equities play an important role in the financial world. They involve different methods or techniques of investing to help people make lucrative returns. You can invest in private equities individually or through a business. A number of companies put their money into private equities to increase their revenue and experience growth.

Once you learn how these equities work, it becomes easier to make a well-informed decision about an investment. Typically, firms that run private equities use two strategies for investing or taking over other companies:

Active private equity

Private equities can invest actively in businesses that they purchase or acquire. This means that the firms offer guidance or support to the companies on a managerial level. Simply put, active private equities can help them run their operations and create strategies that could generate higher revenues.

The idea behind the strategy or method is to help the company make more money and cut down costs so the private equity can earn more profit on their investment.

Passive private equity

Private equities that follow a passive technique depend on the executives or management of the acquired business to boost its growth, so the firm is not involved in the strategising or decision-making of the other company. With this technique, private equity firms aim to invest a minimal amount in the operations to benefit from a higher return.

Related: How to become an investment analyst (with steps and skills)

What is the role of private equities?

Now that you're aware of the general functions of private equities, you may be wondering what exactly private equities do and what role they play in their associated industry. Most such enterprises have the following functions or processes for investing:

Raising capital or funds

Since there's a group of investors or stakeholders in private equities, they can look for more partners to raise funds or increase capital for investment. Sometimes, an investor may also get funds from other businesses or wealthy owners to acquire a company. The general idea is that when more funds are raised, the easier it is for private equities to expand their investment portfolio and generate profits.

Providing funding to businesses

One of the most important functions of private equities is to detect when a business is struggling and invest in it. Many enterprises consider underperforming companies to be profitable, so the investors and their teams identify any growth potential and assess how to make that growth occur. Once private equities can realise the value of a business, they can invest or provide capital to boost its performance.

Offer operational support

Active private equities provide support and assistance with running a company's operations to help maximise its profits. The restructuring they supply can help businesses improve their efficiency down to the management level and produce strategies to meet set goals or objectives more effectively. A private equity firm can play a crucial role in the success of an acquired company by guiding them about techniques or methods that bring higher returns.

Execute deals or transactions

Due diligence or research is a part of every business deal and process and private equities help reinforce these qualities. Once private equities are convinced that a company has potential and could succeed in the future, they close deals for their acquisition or partnership. This can involve negotiating with the owners or stakeholders and reaching an agreement, whereby the equity can execute a deal or transaction where investors could get a larger partnership stake in the company by putting up capital.

Boost business growth

Private equities also help business owners sell their companies for significant profits. When buyers invest in a corporation, they can agree to a deal to sell it later on. A private equity firm can convince them to put the business on the market after it's achieved all of its goals for revenue and growth. This helps direct the company towards the possibility of a lucrative sale early on, as the idea is to help buyers expand their portfolios and get higher returns on their investments.

Related: How to become an investment analyst (with steps and skills)

How do private equities invest funds?

When it comes to investing, private equities can follow various strategies. Here are four common types of funding that they can offer:

1. Leveraged buyouts

A leveraged buyout is when a business is taken over entirely to boost performance and generate additional revenue. Private equities acquire a company to make structural and investiture improvements so it can grow and expand quickly, with the aim of selling again at a higher place or making the company public. Private equity firms choose companies with clear potential that can easily improve with some changes in management or production methods. Following a leveraged buyout, the private equity firm has the power to replace executives or change the company's business model for maximum profits.

2. Venture capital

This involves private equities or investors offering capital to startups or entrepreneurs. It's quite common for companies in certain sectors, such as technology, to get funding or attract investment for expansion in this way. A small business that's looking to enter the market can pitch itself to a private equity firm and develop its products or services with seed money. Venture capital can also be used to finance businesses looking to compete on a higher level. They usually do this in exchange for shares or a partnership. Private equities evaluate startups and assess their potential before putting up capital.

3. Real estate

Most private equities follow the investment strategies mentioned above and may not consider other options. In some cases, commercial and residential real estate can generate a lot of interest from private equity firms. This usually requires a heavy initial investment that can take a long time to give returns since the value of real estate fluctuates.

4. Funds

A private equity firm can also invest in other funds to diversify its portfolio. This is a slightly tricky strategy that may result in lower returns for some of its enterprises while raising others. A firm carries out an appropriate risk assessment before committing to this balancing of investments.

The key benefits of private equity

The following are a few important benefits of private equities that could help you or your business in the long term:

Further investment opportunities

With private equity firms, you can find a range of options to grow your investments. They help manage the money efficiently and allow you to invest it in businesses that are shown to be profitable. Even if you put your money in a company that's certain to expand in the future, you can ensure that you get a high return.

Less pressure from the public

Since a private equity firm functions independently and without public opinion, it can allow businesses to work without any pressure from the outside. When an organisation receives funding from a private equity firm, they're no longer concerned with public trades. They also don't have to answer to several stakeholders with differing motivations.

Related:

  • Private equity vs venture capital: a comprehensive guide

  • What is a venture capitalist? (With roles and examples)

  • What are private equity firms? (With types and benefits)

  • What is a portfolio company? What to include in a portfolio


Explore more articles