Water Ouzel

So now it’s time for everyone’s favorite time of day again – that time when I try to sound intelligent and well-versed in all things investing. I was ‘reading some interesting information’ (aka doing my job and editing boring investment reports) when I started thinking about some stuff the common man might not know about private equity, and I thought I would share my thoughts with him.

First of all, private equity is all that investment action that you, the common man, can’t get in on. It involves trading of stocks not on the public market, usually involving company takeovers and large-scale investments that even the upper middle class will never be able to afford. So. Why do any of us really care, unless we become billionaires? Debt.

I’ve written a bit before about my own skewed view of the current debt and mortgage system, but private equity is a part of that system in a big big way. Basically, a private equity investment company works to develop existing or start-up companies and corporations.  This doesn’t always involve debt, or buying out an entire company, but it can.  A private equity company usually researches a particular market – say, software – with a specific target in mind. Let’s give an example. Let’s say Geronimo is an investment management company in the home appliance market that is targeting undervalued and underperforming companies. That means they look at all the cheapest private companies that make home appliances and try to figure out why those few companies are doing so badly. Then, if they think they can improve the company and generate some money from it, they buy it out, change it around, and sell it for a profit. Of course, sometimes it doesn’t work out like it’s supposed to. Even in a strong market, there could be so many companies that no amount of improvement in one is going to lead to large profits. Or, the market could take a sudden dip, leaving our sad Geronimo with no profit for all its hard work.

The buyout system usually works because the investment companies like Geronimo make enough in one investment to fund months of research and bargaining for another. Plus, once a company like this gets known for its successful work, it gets easier to make attractive buyout proposals to private companies.

The problems we’re facing right now due to a slumping economy increase pressures for private equity – there’s less of a guarantee that an investment will post significant gains. Research becomes even more important. In addition, since the majority of these takeover involve large infusions of capital, many of these private equity companies use debt to make the initial purchase. Which means, of course, if they don’t make good on their investment, they’re actually short of cash due to interest on those loans. Which means, in times of scarcity, the normal private equity players may be more reluctant to taake on a questionable investment, meaning that more corporations may be run inefficiently, which certainly doesn’t improve market conditions. One great big circle yet again. Yay!