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What Is Private Equity?

By Jay Jenkins – Aug 19, 2015 at 9:03PM

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Understanding the high-finance world of private-equity investing

At a high level, private equity is easy to define; it's just an investment in a private company. But when you dive deeper into the details, there's more to private equity than this simple definition implies.

Private equity: The big picture
When someone mentions private equity, that person is more than likely referring to the alternative investment class in which large funds of investor capital are used to purchase companies. Usually those companies are privately owned, but sometimes they're publicly traded.

The fund behind the investment assumes control over the company and then works to increase its value. A few years later, the private-equity fund will seek to sell the company, hopefully at a handsome profit. A typical holding period for a large private-equity firm is usually around four to seven years.

Most private-equity deals use large amounts of debt to pay for the initial acquisition. This practice boosts the firm's return on investment, because it lowers the upfront capital required to do the deal. Some critics, however, argue that the high debt loads are detrimental to the underlying company being acquired.

The debt is paid down by the company's operating profits over time. For the private-equity investors, the debt essentially takes care of itself. But for the company, cash that would have otherwise been available for reinvestment in the company must now go to debt payments. It's a trade-off private-equity investors are willing to make to boost their profits, even if it does create a financial burden for the portfolio company.

Recent examples of private equity at work
Private-equity deals happen all the time, but a few headline-grabbing deals tend to stand out from the rest.

Computer company Dell was bought out in a private-equity transaction in 2013. Dell was publicly traded at the time, so company founder Michael Dell and private-equity firm Silverlake Partners had take the company private to execute the $25 billion deal.

Michael Dell and his management team have since set to work reshaping the company to better compete in today's cloud-based, software-as-a-service world of enterprise technology. It's yet to be seen whether this deal will work out for the company and the private-equity backers. Only time will tell.

Other high-profile examples of late have featured Warren Buffett's Berkshire Hathaway and the Brazilian buyout firm 3G Capital. Together, these two financial powerhouses bought Heinz and then merged it with Kraft Foods to form the Kraft-Heinz Company. Berkshire and 3G have also worked together to buy Burger King and Tim Horton's, two of the largest fast-food chains in North America. Separately, 3G is also the primary owner of iconic American beer company Budweiser.

Private equity and the everyday investor
If all this sounds exciting, that's because it is. Private equity is high finance in one of its most dramatic forms. Billions are made. Empires are built. But, alas for the everyday investor, it's next to impossible to get direct investing access into a private-equity fund.

That's because of SEC regulations that require the private-equity funds to limit their fundraising to so-called "accredited investors." These investors must meet certain lofty income and net-worth requirements just to qualify to make an investment in the a private-equity fund. The vast majority of American's don't make the cut.

However, it is possible to indirectly invest in these funds by buying shares in the parent company that manages the funds. There are numerous options, including an investment in Buffett's Berkshire Hathaway -- even though Berkshire isn't exactly a private-equity firm in the traditional sense.

Investors could also buy shares in notable private-equity companies KKR & Co. or the Blackstone Group. These are giants in the private-equity business, and their shares are both publicly traded on the New York Stock Exchange. You won't have access to the funds directly, but you'll at least have an indirect exposure to the work being done on each private-equity investment within the firm.

There's a time and a place for private equity
Breaking into the business is highly capital-intensive, and it's pretty risky. It's also highly lucrative.

But for most retail investors, it's not realistic to invest your own capital as most private-equity funds do. Likewise, there aren't many options to invest in the funds directly unless you're accredited and really, really rich.

If you're bent on adding private equity to your portfolio, the most realistic option is probably just buying shares in the firm itself from the publicly traded market. It's not a perfect solution, but it will work for every investor.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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