The Functions of Private Equity

The Carlyle Group is a U.S. private equity firm.

The Carlyle Group is a U.S. private equity firm.

Private equity is often discussed in the financial and business press. At times it is maligned; at other times, championed. Private equity has existed since capitalism began. Long before public stock markets existed, companies had to tap private individuals and businesses for the equity needed to start and grow their businesses. As this has morphed into more formal private equity and venture capital firms that seek out businesses to invest in or buy, the crucial functions still remain.

Expansion Capital

Private equity and venture capital firms provide the funds that businesses need to finance growth. Often firms that have inconsistent operating cash flow due to operational issues or changing market conditions cannot qualify for enough bank financing. In addition, rapidly growing businesses often use up their operating cash flow in acquiring assets or personnel. Because their operating cash flow may turn negative due to these expenses, they also do not qualify for debt financing. In addition, if these companies obtained all the financing they needed in the form of debt, they may be unable to make the debt payments.

Discipline

Private equity often provides the discipline companies need. For public companies taken private through a private equity transaction, discipline is less of a function. These companies had to meet the standards and expectations of the public markets. However, for many private companies, those without external boards and oversight often operate the companies according to the owners’ whims. Owner-managers often have different criteria than those that are purely shareholders. Private equity generally demands that companies operate efficiently to drive an increase in shareholder value and put the personnel, systems and processes in place to ensure this.

Management

Private equity provides management. Many companies that private equity firms invest in have thin layers of management. They often have the founder or founders in various roles and may have one or more vice presidents. Private equity provides not only the capital to hire more management, but also the expertise and resources to identify and screen management. Private equity also may replace some or all of the current management with outsiders skilled in a particular industry or market niche. In addition, private equity provides board members with varying perspectives and insights.

Contacts

Private equity provides contacts and resources. Fast-growing technology firms can harness the know-how from a venture capitalist firm’s stable of past and current companies. These firms can connect with industry insiders who can help the company obtain contracts, partnerships and exposure that they would either not have had access to or would not have known about.

Overall Function

The overall function of private equity is to drive an increase in shareholder value. A consequence of this is better capitalized, better managed, more resourceful and disciplined companies. Beneficiaries of private equity grow faster and stronger, use the services of more companies and employ more people. This creates a ripple effect, producing a significant positive impact on the U.S. economy.

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