What is Private Equity?

Private equity, or “PE,” is an asset class that seeks to invest in unlisted companies and is typically considered an illiquid investment. The overall concept of private equity is to make an equity investment in a highly illiquid security over a longer term period (3 to 5 years) to receive high rates of realized return (approximately 30% internal rate of return, or “IRR”) on initial investment. These returns are reached through the use of leverage, such as bank debt.

For example, a private equity investor purchases a business that has had LTM EBITDA of $10 million for $50 million total or 5x LTM EBITDA. Of the $10 million to acquire the business, the private equity investor can put down $4 million in equity and use $6 million of borrowed money to fund the purchase. Over the hold of the investment, the business’s free cash flow is used to pay off debt and interest expense. The pay down of outstanding debt increases the equity to debt ratio or equity part of the capital structure which is held by the investor. If the business is sold for $100 million after 5 years, the investor would receive a larger amount of capital (if exiting at the same entry multiple) given the larger percentage ownership and higher valuation. The overall return the investor receives is determined by the exit cash flow of the company (EBIT or EBITDA), the exit multiple and the amount of debt that is paid off over the time horizon of the investment. The investor would calculate his or her realized performance, or “track record,” in terms of the IRR on initial investment over the 5 year investment time horizon.

It is estimated that private equity firms manage approximately $1 trillion dollars worldwide today. In recent years and especially right before the 2008 and 2009 market crash, private equity has captured a larger image and public interest.

A recent private equity transaction example is the acquisition of J.Crew Group, Inc. (NYSE:JCG) by TPG Capital and Leonard Green & Partners for $43.50 per share in cash. This deal was announced on November 23, 2010 and J.Crew’s stock price jumped approximately 16% on the news. TPG Capital is the global buyout group of TPG, a leading private investment firm founded in 1992, with more than $48 billion of assets under management (AUM). Leonard Green & Partners is a leading private investment firm with over $9 billion in equity capital under management.