What is Private Equity? How Does it Work?

Q: What is private equity? How does it work?

A: Charles Duhigg - winner of the Pulitzer Prize for Explanatory Reporting- answers that question at the 11-minute mark of a video you can find on YouTube called "Inside the Private Equity Game." The transcript is below:

So why do companies just shift hands from one private equity group to the next private equity group to the next private equity group? 

One of the really big reasons why is because of how the private equity industry is structured, and how private equity professionals get compensated. 

So let's say I'm raising a private equity fund, The Charles Duhigg Fund, and I'm going to raise a billion dollars. The way that I get paid is I get what's called "2 and 20," which is 2% of the money that I have under management and 20% of the profits. 

But I only get that 2% once I've put the money to work. In fact, I only get the money once I found a deal to put it into, otherwise it just stays with my investors in my investors' bank account. 

So let's say that I've promised everyone that I'm going to put all the money to work by year 4 and it's now year 3 and it's a billion-dollar fund, and I've only invested $500 million. 

Now I've got a year to put $500 million to work. And what's more, if I don't do it within the next year,  my investors get to keep the money. They don't have to give it to me at all. 

So now I'm out there and I've got 12 months to put $500 million to work. It took me 3 years to put the other $500 million to work, so I'm literally going to do any deal I possibly can as long as it's not going to blow up in my face and make me look like an idiot. 

So if you bring me a deal and you tell me, "Look, the price we're selling it at, it's going to be the exact same price three years later," I'm still going to do that deal because then I can go to my investors and I can say, "Look, I found a new deal. It is going to cost $300 million." Now I get 2% of fees on $300 million. I don't have to give the money back. Everything is happy. 

The question then becomes, "Why does the guy on the other end of that deal do the deal with me? Why does he give me the company for $300 million?" The reason is because he's in year 7 of his fund, and things are about to shut down in year 10. And what he promised everyone was, "We will be exited out of all of these investments by year 10." 

Now, let's say that this guy has exited out of no investments because the stock market is down, and because he can't find any buyers, and because it turns out it wasn't such a great deal in the first place, and he overpaid. What he's going to do is [say to himself] "Look, as long as I can find a buyer who's willing to give me a price that isn't embarrassing, I'm going to get out of this deal because then I can turn to my investors and say, 'Look what a genius I am! I got us out of this deal!' And by the way, I did it before year 10, which means that we all get to keep the money and I get my percentage that I am promised. 

So you have a whole bunch of guys sitting in sort of a daisy chain, and even though there isn't any economic value being created by handing companies around that daisy chain for the company itself, you're creating economic value for the professionals who are handing them around because they get paid to basically do deals. That's what happens on Wall Street. You get paid to do deals."

– Charles Duhigg