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Private equity: So misunderstood

Private equity has become a controversial presidential campaign topic. Private equity is so poorly understood, however, that people are taking sides without fully understanding it and its role in an economy.  I strongly believe that it is important to educate the public about the basics of private equity so they can make an informed decision.

Is private equity a vulture, or it is an economic growth enabler? I will answer this question by explaining the following three points: Why should you care? How does private equity work? What does it do for the economy?

Why should you care about private equity?

A private equity fund is comprised of general partners and limited partners.  General partners run the fund, seek out new investment opportunities and play an active role in the management of the companies in which they have invested.

The limited partners invest in the fund.  They are usually institutional investors, such as pension funds or insurance companies. Those of you who rely on some type of pension for your retirement have personal interests in the financial well-being of private equity.

Even if you don’t expect to receive a pension, if you purchased any life insurance products, any long-term care products or any annuity products from any insurance companies, chances are these insurance companies have invested at least a portion of your premium into private equity. Therefore, you have skin in the game when it comes to the financial outcome of private equity.

How private equity works

A private equity fund is an investment vehicle that provides financing to under-valued companies in exchange for a percentage of their shares. Private equity firms generally invest in companies for several years or more. The goal is to work with management to improve the company’s performance and make it a stronger, more competitive enterprise.

Private equity firms will work to enhance the companies’ value, then sell them or the share they own. In doing so, private equity firms can either return the profit to their investors or raise capital for new deals. 

I want to share a story about the Detroit Medical Center, a collection of eight hospitals and one rehabilitation institute caring for an underserved, urban population. DMC receives over 1.4 million patients on an annual basis.

During the recession, DMC was capital constrained and forced to delay major new capital projects. In December 2010, a private equity firm, Blackstone, acquired the DMC for $368 million. More importantly, it was willing to maintain DMC’s charity care policy.

The acquisition represents the largest ever conversion (in terms of revenue) of a not-for-profit hospital system in the U.S. As part of the acquisition, Vanguard committed to invest $850 million over five years for capital improvements and routine maintenance. This is the single largest private investment in Detroit history. Blackstone’s deep operational expertise and sector knowledge are helping the company implement a series of operational efficiencies. Over the five- year commitment period, the construction projects are expected to create 5,000 jobs.

There are many success stories like the DMC in which private equity firms played important roles. The key to their success is their ability to bring efficiencies to an otherwise disorganized company.

Private equity investors take an active interest in the businesses that they finance. They will want to be actively involved in your key management decisions, working with you to help your business achieve its potential. Cost cutting is one of the many ways to unlock the potential value. Other often used techniques are identifying new revenue sources or revising the business model.

What does it do for the economy?

There are more than 2,400 U.S. private equity firms and 3,400 worldwide.  These firms invested more than $1.6 trillion in 15,200 American companies over the last 10 years.  They are investing in companies that employ more than 8 million workers worldwide.

Do you know there are private equity firms taking on a key role in the economic reconstruction of the Middle East and North Africa in the aftermath of last year's Arab Spring revolutions?

Private equity goes wrong when the general partners get greedy. There is the tactic called over leverage, which entails piling a bunch of unwanted debt on a company with no debt on its balance sheet. That can juice the equity returns and put the smaller company at risk, potentially leading to bankruptcy.

Ultimately, private equity is a tool. It is a unique form of funding that, used wisely, can drive business along the fast track to market leadership.  It has been and will continue making great contributions to our economy.


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Helen Raleigh

Helen Raleigh, CFA is the owner and Chief Investment Officer for Red Meadow Capital, LLC, a Colorado Registered fee-only Investment Advisory Firm, which focusing on providing clients with honest and sound financial advice. She has more than 10 years experience in the financial services industry ranging from pension funds to risk management. Helen is the author of an autobiography, "Confucius Never Said."  She writes insightful columns and blogs for a variety of media outlets and her writings can be found at the Wall Street Journal, the CFA Magazine, the Denver Post and her blog postings. She can be reached at: helen.raleigh@redmeadowadvisors.com

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