How Private Equity Firms Make Money
Or how they claim to, anyway...
Hi all, welcome back!
Today we’re putting the statistics aside and will talk about something a little more tangible — the topic of how PE firms actually make their money. If you hit a term you don’t recognise, I’ve included a simple glossary at the bottom of this post.
At a high level, PE firms raise capital from institutional investors and high-net-worth individuals, pooling it into funds used to buy ownership stakes in companies. These aren’t start-ups — they’re usually established businesses that have hit a rough patch (like poor leadership) but still generate stable cash flow.
PE firms aim to buy these companies at a discount, improve them, and then sell them for a profit. This process involves a leveraged buyout (LBO), where the firm uses a large amount of debt to finance the purchase. The idea is that debt amplifies returns — if things go well.
Once acquired, the PE firm takes control — either directly or by installing new leadership. They’ll typically look to cut costs, streamline operations, or sell off unprofitable divisions. After 3-5 years, the goal is to exit: selling to a corporate buyer, going public via IPO, or flipping it to another PE firm.
If the play works, they sell for far more than they paid. They earn profit through this sale, plus management fees and a performance bonus called “carried interest”. But there’s significant risk — PE investments are less liquid and more volatile than stocks or mutual funds. That said, when it works, the upside can be huge.
Strengths and Weaknesses of PE
PE is the definition of high risk high reward. When looking at strengths within this firm structure, you should be thinking of:
High return potential - Top performing funds can generate 20-30% IRR
Operational control - PE firms can install new leadership and drive strategic change
Alignment of interests - Managers often receive equity to align incentives
Flexibility - Not bound by quarterly reporting like public companies
But amongst this sea of good news, weaknesses definitely exist:
High risk - Leverage amplifies losses if the plan doesn’t work
Illiquidity - Money is locked in for 5-10 years
Opaque structures - Fees (2% management + 20% carry) can be complex
Social impact - Layoffs and aggressive cost cutting can be controversial
A great example of a company which was negatively affected by the influence of a PE firm is Toys “R” Us, a popular kids toy store. In 2005, Toys “R” Us was taken private by Bain Capital (https://www.baincapital.com), KKR (https://www.kkr.com), and Vornado Realty Trust (https://www.vno.com) for a purchase price of $6.6 billion. This deal was conducted through a Leveraged Buyout, meaning that Bain, KKR, and Vornado put together about 20% of the purchase price from their own equity (approx. $1.3 billion), and the remaining 80% was mostly secured by Toys “R” Us’ own assets, as well as bank loans and high-yield “junk” bonds (approx. $5.3 billion). This meant that the company, not the PE firms, was responsible for repaying the debt.
Toys “R” Us had extremely strong brand recognition as well as real estate assets. The acquirers calculated that the business would generate enough EBITDA to cover interest, and that there was room to streamline operations, cut costs, and maybe sell off smaller units like the Babies “R” Us range.
Seems like a good deal, right?
Wrong. The late 2000s was a devastating time within markets due to technological adoption, as well as the 2008 financial crisis. The huge amount of debt placed onto Toys “R” Us made it so that even in moderate economic downturns, cash flow would hurt badly. Introducing Amazon and Walmart, online accessibility skyrocketed and brick and mortar businesses feel the effects. Finally, because cash was needed to service the debt, they underinvested in stores, tech, and online (low CapEx spend).
So how did it end for the PE firms?
2017 - Toys “R” Us files for bankruptcy
$400 million in annual interest payments
Over $5 billion in debt remained
Stores were liquidated, over 30,000 jobs were lost
Not such a pretty scene.
So, if I was in PE, what can I do to see if a business is truly undervalued?
Is the company underperforming vs peers?
Mismanaged?
Rich in assets (e.g. real estate; intellectual property)?
Operating in consolidating industries (where companies in the same sector begin to merge)
And to determine these answers, we can use tools such as:
EBITDA multiples - the comparison of a company’s enterprise value (EV) to its EBITDA. Essentially shows how much the market is willing to pay for each dollar of a company’s operating profits
DCF (Discounted Cash Flow) Analysis - a valuation method used to estimate the value of an investment based on its expected future cash flows
Comparable Transactions - what similar companies were bought for
For example, a PE firm spots a regional hostel chain with steady occupancy, but poor online booking capabilities. With digital marketing improvements, they project a 30% revenue boost
How do PE Firms Improve Companies to Resell?
This is a process known as “value creation” and may involve:
New management - replacing founders or underperforming executives
Cost-cutting - removing bloated SG&A expenses (Selling, General, and Administrative expenses are costs a company incurs in its day-to-day operations that are not directly related to producing goods or services)
Process optimisation - improving margins (e.g. renegotiating supplier contracts)
Growth strategies - expanding into new markets or geographies
Add-on acquisitions - “buy and build” strategy
Example: A PE firm buys a logistics company and digitises its routing software, saving €2M annually. After 4 years, they sell it for 2x the original price
How Do PE Firms Strip and Sell Businesses?
In a more cut-throat way, sometimes value is created by breaking up the company. This can include:
Carve-outs - selling a business unit to a strategic buyer
Asset sales - real estate, licenses, patents
Spin-offs - creating standalone entities from divisions
Example: A PE firm acquires a media conglomerate. It sells off the printing division to a competitor, spins off the digital unit, and shuts down unprofitable magazines, thereby unlocking value in the remaining brand portfolio.
Whether it’s through operational improvement or strategic break up, private equity firms rely on a strong mix of finance, strategy, and risk management to create value. Take this with a grain of salt, because with high returns come high risks — and just like with Toys “R” Us — the outcomes aren’t always pretty. Understanding the tools, incentives, and tactics used by PE firms helps demystify an industry that’s often misunderstood.
Speak soon,
Rhys
Definitions:
1. Private Equity (PE)
A type of investment where firms pool money from investors to buy ownership in private companies (or take public companies private), with the goal of improving and later reselling them for a profit.
2. Institutional Investors
Large organisations like pension funds, insurance companies, and endowments that invest significant sums of money.
3. High-Net-Worth Individuals (HNWIs)
Wealthy individuals who invest large amounts of capital, often into private funds like PE.
4. Leveraged Buyout (LBO)
A deal structure where a company is bought using a small amount of equity and a large amount of borrowed money. The acquired company’s own assets are often used as collateral for the loan.
5. Equity
Ownership in a company, usually represented by shares. In PE, this is the portion of the purchase paid for with investor cash.
6. Debt
Borrowed money that must be repaid, typically with interest. In LBOs, this makes up most of the purchase price.
7. Interest Payments
Regular payments made to lenders as a cost of borrowing money.
8. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation)
A measure of a company’s operating performance. It’s often used by PE firms to assess whether a business generates enough cash to cover debt.
9. Internal Rate of Return (IRR)
A percentage used to estimate the profitability of investments over time. It considers the timing of cash flows and is a common metric for PE performance.
10. CapEx (Capital Expenditure)
Spending on long-term assets like equipment or property. Low CapEx usually means underinvestment in business growth or maintenance.
11. SG&A (Selling, General, and Administrative Expenses)
Day-to-day costs not directly tied to production, like salaries, rent, and office expenses.
12. Carried Interest
The share of profits (usually 20%) that PE fund managers earn if the fund performs well — it’s their performance-based bonus.
13. Illiquidity
The difficulty of converting an investment into cash. PE investments are illiquid because money is tied up for years.
14. EBITDA Multiple
A valuation tool comparing a company’s total value to its EBITDA. Helps investors see how expensive or cheap a company is relative to earnings.
15. Enterprise Value (EV)
A measure of a company’s total value, including debt and excluding cash — often used in valuation calculations like EBITDA multiples.
16. Discounted Cash Flow (DCF)
A method of valuing a business by estimating its future cash flows and "discounting" them to present value using a required rate of return.
17. Comparable Transactions
Looking at what similar companies were sold for in the past, used as a benchmark for valuation.
18. Carve-Out
Selling off a specific division or unit of a larger company, often to unlock hidden value.
19. Asset Sale
Selling individual parts of a business (like real estate, trademarks, or patents) rather than the whole company.
20. Spin-Off
Creating a new, separate company from a part of an existing business.