What Are Private Equity Firms and How Do They Work?

By Indeed Editorial Team

Updated July 28, 2022 | Published April 13, 2021

Updated July 28, 2022

Published April 13, 2021

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.

Related: Becoming a Private Equity Associate

Are you interested in a career in Private Equity but not sure how to start preparing for it? We have you covered!

Companies often rely on investors to develop and grow successful businesses. Similarly, investors often view companies as investment opportunities to increase their own funds or capital. Understanding what a private equity firm is can help both investors and businesses make more informed financial decisions.

In this article, we discuss what private equity firms are and what they do, then list the types of private equity firms and funds to help you understand this finance concept thoroughly.

What are private equity firms?

Private equity firms are investment firms that buy private stakes in companies. These firms use their own funds or capital from other investors to purchase stakes in companies and startup operations. Firms may also purchase companies through auctions. Private equity firms often help the companies they purchase to improve their operations, cut costs and increase their value.

Each private equity firm has investors who prefer to directly invest in companies instead of buying stock. Investors in private equity firms may be interested in funding companies for personal reasons or to improve business operations. These investors often earn management fees and receive a percentage of the gross profits when the firm sells the company, or they may receive their ROI, or return on investment, through the following methods:

  • Acquisition or merger

  • Initial public offering (IPO)

  • Recapitalization

Related: Equity: Definition and How It Works

What is private equity?

Private equity is a type of financing related to investing money or capital into a company. Private equity allows investors to purchase parts of or an entire public or private company. These are companies that are often not publicly listed or traded.

Private equity ownership allows investors to gain an equity or ownership stake in the company. Private equity ownership differs from stock ownership. It allows investors to purchase stakes or ownership in a company. They invest in companies to gain control over some of the company's operations, whereas passive investors only invest in companies to earn financial gains.

Related: What Is Stockholders’ Equity? Definition and Formula

What do private equity firms do?

Private equity firms handle a variety of investment responsibilities. In general, investors at firms gather funds, help companies grow and assist with the reselling of companies. Specific responsibilities may vary for each private equity firm or agreement. Here are some of the general responsibilities of private equity firms:

Raising capital

Private equity firms gather capital to invest in companies. Investors may seek and acquire capital commitments from limited partners or external financial institutions. Some investors may use their own money as contributions for the investment. Many private equity firms seek limited partners to provide the majority of the capital to invest.

Related: Equity vs. Debt: Types, Pros and Cons

Sourcing

Private equity firms analyze potential companies to invest in or acquire. They consider factors like:

  • What the company does, such as their product or service

  • What industry the company is in

  • How well the company performed financially in recent years

  • Who is on the company's senior management team

  • What the company's valuation is

  • What potential exit scenarios are for the company

Private equity firms may use their own network, make cold calls or work with investments to connect with companies. Companies will sometimes contact private equity firms themselves based on the firm's reputation to source prospective potential deals.

Related: What Is Private Equity? (Plus FAQ About Private Equity)

Performing due diligence

Once a firm sources a deal, they perform due diligence to further assess the company. What a firm finds during its due diligence affects whether they offer a formal deal. Firms examine things like:

  • The company's strategy

  • The exit potential

  • The company's business model

  • The risk factors

  • The company's financial health

  • The company's industry and market

Read more: Due Diligence Checklist: What To Know

Closing deals

After completing due diligence, the firm presents a deal to the company. Lawyers from the firm and company negotiate the final terms of the deal. Once agreed upon, the deal can proceed, releasing funds and trading equity on both sides.

Improving operations

Private equity firms can help improve the health of the company. They often make recommendations to help improve operations, cut costs and improve management. The extent of the firm's responsibilities may vary based on their stake in the company.

Most private equity firms do not involve themselves with the day-to-day operations of their portfolio companies. Firms with more significant stakes in companies may have a stronger presence or hold a leadership position within the company. 

Related: Investment Banking vs. Private Equity: Key Differences

Exiting companies

Most private equity firms strive to exit their portfolio companies when the company is stable and successful. This may help ensure they receive the maximum return on their original investment. Most firms exit within three to seven years, but timelines can vary depending on the firm’s specific strategy.

Related: Business Exit Strategy: Definition, Types and When To Use Them

Types of private equity firms

Private equity firms have different investment preferences. For example, some firms are passive investors who rely on management to operate and develop the company. Other firms are active investors who provide operational support to the company to help it grow and succeed.

Active private equity firms often have many connections and strong relationships with C-level professionals within individual industries. These connections can help them generate revenue and improve a company's operational efficiency and synergy.

Sellers may consider this a benefit as the firm or investor can provide resources that improve the company's value‌.

Related: 35 Private Equity Interview Questions (With Sample Answers)

Types of private equity funds

There are many types of private equity funds or investment strategies. The most common types of private equity funds are:

Buyouts or leveraged buyouts

A buyout or leveraged buyout (LBO) occurs when a private equity firm entirely buys out a company. The firm may finance the purchase through debt or funds by using the company they're purchasing as collateral.

This allows private equity firms to assume complete control of companies without having to spend as much money. Buyouts or leveraged buyouts often allow private equity firms to maximize their potential return on investment when they sell the company.

Related: How To Become a Private Equity Associate

Venture capital

Venture capital (VC) strategies involve a private equity firm investing in new companies in relatively new industries. This can create the potential for the firm to maximize its returns if the company succeeds in the industry. Venture capital investments can carry much higher risks since companies aren’t yet established and their products or services are relatively untested in a broader market.

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