Have you noticed the boom in private equity funds? Five years ago, private equity funds closed $37 billion worth of acquisition deals. In 2006, the total value of private equity deals was $475 billion. Today there are at least 170 private equity funds with at least $1 billion in assets.
Private equity funds have been doing so well that Wall Street and the financial press have not been alone in noting their success. Congress is exploring the ways in which publicly traded private equity funds are taxed on their profits. Current tax law sees them as partnerships, allowing the general partners’ share of profits to be treated as capital gains that are subject to a maximum 15% tax rate. But some legislators are pushing to treat these profits as income, which is subject to higher tax rates.
Private equity is probably going to be in the news for a while longer. This primer may help you follow the story.
Borrow, Buy, Improve, Sell
Private equity firms typically use a combination of investor funds and bank loans to buy companies, often by buying the outstanding shares of publicly traded companies and effectively taking them private, in the sense that the shares are no longer traded on the stock market.
Once a private equity fund has control of a company, it usually places the debt burden on the newly acquired company, forcing management to become more efficient in order to carry the new debt load while also remaining profitable. But the reorganization of the acquired company does not stop there. Private equity firms typically have at least two goals for their acquisitions: (1) reorganize the company so that it reaps profits for them while they own it and (2) make the company valuable enough to resell at a profit in a few years.
No longer are absent shareholders carrying the risk for a company they own but are not involved in running. The fund itself gets to keep all the profits, which provides a powerful incentive for the fund managers to make the company profitable. This pursuit of efficiency and value can result in drastic changes for the acquired company.
The blueprint is not unlike what real estate investors do with a so-called fixer-upper: obtain a large loan to buy the asset, fix it up as quickly as possible, and resell it at a profit.
Using leverage in this way has some appealing profit potential. Say that a private equity firm buys a company for $20 million by putting up $5 million of its own money and borrowing $15 million. If the fund is able to increase the value of the acquired company even by just 5%, this equates to a 20% gross return on its initial $5 million investment.
Awash in Cash
The current popularity in the private equity market funds is due not to a surfeit of underperforming companies, but to an abundance of liquidity. The U.S. money supply has been expanding rapidly. Eight months into the budget year, the federal deficit was down 34%. The Chinese have been buying Treasury bonds at historically low interest rates because of our trade imbalance with China.2 In other words, money has been cheap, and private equity firms have taken advantage of low borrowing costs to leverage enormous purchases.
It is not clear where the private equity trend is headed. As we see interest rates creeping up, the supply of cheap capital is bound to dry up, making these types of deals less attractive. But in the meantime, it’s another reminder that tremendous opportunities can occur in a free market.