The term “private equity” evokes many emotional reactions. Many investors have made a lot of money thanks to the strategies being followed by private equity companies. However, many companies no longer exist because of these private equity funds. The investments being made by these funds is rapidly growing.

Private equity funds have a lot of money, and they are looking for acquisition targets.

In this article, we will have a closer look at the some of the strategies which are commonly used by private equity firms in order to conduct business.

Why Do Private Equity Firms Make Money?

Private equity firms are known for acquiring businesses which are either publicly listed or privately owned parts of publicly listed companies. Their business is based on identifying companies which are not aggressively managed. As a result, the valuation of these companies is not very high.

Private equity firms take complete control of these firms since the potential isn’t readily apparent to the world. Private equity funds then make aggressive changes to the company.

Unlike public companies, these funds have a starting and an end date. Hence, the precise return on an investment made by the fund can be accurately measured.

The idea is to turn around the company within a period of two to six years and then sell and move on the other opportunities. However, when private equity companies invest their money, they tend to monitor the performance of their investment constantly. Hence, these companies are always under the radar. The mere pressure of continuously being monitored ends up creating better performance in many instances.

Here are some of the features that help identify a typical private equity deal.

• Higher Than Average Returns: Private equity firms are not looking to earn market rates of return. Instead, they want to take high risks and receive a premium within a short period of time.

  For instance, when they take over any company, the returns in the first three to four years are double when compared to the average. When their investment starts giving average returns, private equity funds liquidate them so that they can move on to the next venture.

  Sticking with an investment that provides average returns dilutes the overall performance of a fund. Hence, if stocks give 12% return on average, private equity investment firms will not risk their money if the IRR is less than 25%. This is the reason why private equity is known as being a high-risk, high return investment.

• Non-Core Targets: An empirical analysis of data shows that non-core businesses of conglomerate companies are the most common targets for private equity firms.

  Conglomerate firms manage many unrelated industries. However, the bulk of their revenue and profits come from a few core businesses. Since the rest of the firms do not add a lot of value, they are often poorly managed or neglected. This is where private equity firms can rise up to the occasion and help create better value by improving the management of the firm.

• Debt and Tax Benefits: Deals carried out by private equity firms are highly leveraged. Since these firms want superior returns, they tend to use a lot of leverage. In many cases, the cheaper cost of debt capital and the tax advantages turn out to be beneficial, and the company ends up creating more value.

  However, high amounts of debt are also considered to be one of the biggest reasons why private equity deals fail. The bankruptcy of “Toys R Us” which was a multi-billion dollar company is a testimony to this fact.

Challenges for Private Equity

Private equity funds are known to perform well under certain market conditions. When these market conditions change, these funds are likely to face a lot of challenges. Some of the problems are as follows:

• Rising Interest Rates: As mentioned above, debt financing is very common in private equity deals. This is the reason why private equity deals are more sensitive to interest rate fluctuations than other firms.

  The problem is that the Fed has confirmed that they will raise the base interest rate several times over the next year. As a result, the cost of debt will increase. This could mean that financing private equity deals will become more expensive.

  As a result, the profitability of these deals will be reduced. Private equity firms need to liquidate their investments before the interest rates start rising or they may have to liquidate their investment at a lower valuation.

• Difficulties in Cashing Out: IPO’s are the most common ways that private equity firms exit their investments. The problem is that markets can only absorb a limited number of IPO’s at one go. If too many IPO’s are planned, none of them will be able to provide the required rates of return.

The bottom line is that private equity is an effective way for conglomerates to spin off some of their non-core businesses. However, private equity is highly dependent on interest rates and is therefore cyclical. Investors need to be mindful of the interest rate cycle before they put their hard earned money into a private equity fund.