WTF is PE?

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3:15Today, I want to double-click on P.E. or private equity. It's a part of the financial world that's at times mysterious, at times celebrated, even at times controversial. And I want to unpack how it works, who's involved, and why it is both loved and loathed. At its core, private equity refers to investments made in companies that aren't listed on public stock exchanges. And often these investments are made by firms that specialize in PE. Unlike publicly traded companies, which anyone can buy shares in through the public markets, private equity involves buying stakes in private companies or even taking public companies private.

3:53PE firms basically pull a bunch of money from uber wealthy elite pension funds and other institutions to acquire these companies with the goal of eventually selling them for a profit. So it follows the same principle of buy low, sell high. But instead of buying and selling shares of a company using this principle, PE firms are trying to buy whole companies low and sell whole companies high. Private equity as we know it today really took off in the 1980s, though its origin story does go back further. In the 1940s and 50s, early versions of private equity firms emerged, focusing on financing high growth startups, similar to what venture capital or VC does today.

4:34But it was the leveraged buyout boom of the 1980s that truly defined the modern PE landscape. More on LBOs or leveraged buyouts in a bit. But first, the turning point. One of the most famous examples of this era is the buyout of RJR Nabisco by Kohlberg, Kravitz, Roberts & Company, or KKR, in 1988. Yep, PE also has a lot of alphabet soup here, but you already know this because, well, finance. The deal was valued at$25 billion, making it the largest buyout at the time, and it was immortalized in the book and then the movie Barbarians at the Gate, which I highly recommend, by the way. This deal showcased both the potential for massive profits and intense scrutiny and criticism that P.E.

5:20can attract. The P.E. model makes the firm money in three ways. First, management fees. PE firms charge their investors a management fee, typically around 2 % of the total assets under management. This fee is charged annually and it's meant to cover the operational costs of the firm. Then there is carried interest. And this is a big one. Carried interest, or sometimes just called carry, is a share of the profits, usually around 20 % that the PE firm earns when they successfully sell a company at a profit. The remaining 80 % goes back to investors. This means that PE firms only get this payday if the investment pays off.

5:58So they have a big incentive to make those companies more valuable. And file that little tidbit away for later. And number three, dividends and fees. Sometimes PE firms can extract dividends and other fees from the companies they acquire, which can provide additional streams of income. So you might be thinking that PE sounds very similar to VC, but there are some differences. VC firms typically invest in startups or early-stage companies that are seen as high-risk, high-reward. PE firms, on the other hand, usually invest in more mature companies that are established but need help getting to the next level.

6:32The ownership stakes are normally pretty different, too. VC firms often take minority stakes in companies, while PE firms generally acquire a controlling interest or even 100 % ownership. Also, PE deals are usually much larger than VC investments. While a VC might invest millions, PE firms often deal in hundreds of millions or billions. Same, same. Just kidding. PE firms typically look for companies that are mature and have stable cash flows, but may be underperforming relative to their potential. These companies could be in any industry, from retail to healthcare to technology. Often these are companies that could benefit from a restructuring, cost-cutting, or a shift in strategy.

7:15And even though some of these big PE firm names aren't necessarily household names, some of the success stories definitely are. Like, even if you haven't heard of TPG Capital, you've definitely heard of Burger King. And fun fact, Burger King is a PE success story. Back in the early 2000s, Burger King was struggling. But after being acquired by PE firms TPG Capital, Bain Capital, and Goldman Sachs Capital Partners, the company was turned around, rebranded, and eventually taken public again with a much stronger performance. Hilton Hotels is another PE success story. In 2007, Blackstone acquired Hilton for$26 billion.

7:52Despite the timing right before the financial crisis, Blackstone helped Hilton expand and improve operations, leading to one of the most successful IPOs in 2013. So doesn't this sound like something you'd want to be in on? Well, it's a little tricky. Historically, private equity has been this exclusive club and only accessible to institutional investors and the ultra, ultra wealthy. This is because PE firms typically require large minimum investments, often in the millions of dollars. And the investments are illiquid, meaning you can't easily sell your stake if you need money or you want to get out.

8:26But there are some ways for retail investors, folks like you and me, to get a taste of the private equity world. You can actually buy shares in publicly traded private equity firms like Blackstone, KKR and Apollo Global Management. it. This gives you indirect exposure to the P.E. market through the public market, which feels counterintuitive, but it's a weigh in all the same. But P.E. isn't always a slam dunk, nor does the industry have a flawless reputation. The reputation has been warranted at times. Critics argue that P.E. firms can sometimes prioritize profit over the long term health of a company.

9:01The big culprit is debt loading here. So yes, it is leveraged buyout time. In LBOs, PE firms load the company with debt to finance the purchase. This can saddle the company with heavy interest payments, making it harder to invest in growth. And then there's the intense cost-cutting and quick turnaround that it's known for. Because PE firms are trying to sell the companies for more money than they bought them for, they want to make these companies as profitable as possible ASAP, which means a lot of cost-cutting. This is the little tidbit I told you to file away. And while cost-cutting can make a company more efficient, it can also strip it of essential resources, leading to a decline in quality, innovation, or customer service.

9:46And on the quick turnaround front, PE firms usually aim to sell their acquisitions within a few years, which can lead to a focus on short-term profitability rather than long-term stability. These pitfalls have led to some pretty public failures. Toys R Us is maybe the most famous PE flop. The company was acquired by KKR, Bain Capital, and Vernada Realty Trust in 2005. The company was loaded with debt and struggled to keep up with changing retail dynamics. By 2017, the debt burden was way too heavy and Toys R Us filed for bankruptcy, ultimately leading to its liquidation. Another cautionary tale, Sears was acquired by ESL investments led by Eddie Lampert in 2004.

10:29Lampert's strategy of cost cutting and selling off assets left the company hollowed out and after years of decline, Sears filed for bankruptcy in 2018. For today's tip, you can take straight to the bank. If you want to get in on the PE game, there are also some funds and ETFs that invest in private equity or private equity-like investments, which do offer more accessible entry points for individual investors and more diversification to help protect your Burger King deals from your Toys R Us ones.

11:02Money Rehab is a production of Money News Network. I'm your host, Nicole Lappin. Money Rehab's executive producer is Morgan Lavoie. Our researcher is Emily Holmes. Do you need some money rehab? And let's be honest, we all do. So email us your money questions, moneyrehab at moneynewsnetwork.com to potentially have your questions answered on the show or even have a one-on-one intervention with me and follow us on Instagram at Money News and TikTok at Money News Network for exclusive video content. And lastly, thank you. No, seriously, thank you. Thank you for listening and for investing in yourself, which is the most important investment you can make.