Get ready to hear a lot more about the world of private equity. Mitt Romney’s Republican challengers have only just begun to paint Mitt Romney as a heartless corporate raider. If Romney does win the Republican nomination, we can expect most self-respecting Democrats to eagerly pile on about the evils of private equity shops such as Bain Capital and Carlyle Group.

But private equity is a rather elastic term, and it’s not usually the sort of financing that’s considered relevant to entrepreneurs. When CEOs of growing companies do refer to private equity, or their need for ‘an equity partner,’ they’re usually hoping for something much different than the types of deals we associate with Mitt Romney and his ilk.

The Equity Funding Hierarchy

For many entrepreneurs, private equity is a crucial form of financing when they’ve run out of other options for growth. Those options start with angel money at the very early stages, and run through various forms of venture investments.

Angel investments are made by affluent individuals when companies are in their earliest stages. An entrepreneur sells a chunk of his or her company, and that money helps launch the business. At this stage, the entrepreneur may have a product, revenues, a few customers, or just an idea.

Angel investors used to be affluent people who made investments as a way of staying in the game. That’s still true, but they’re now also more likely to work in organized networks that do due diligence together, can offer a wider range of expertise to entrepreneurs, and command larger sums of money.

Next is venture capital, which is probably the best-known, most-hyped variety of early stage investing. Venture capitalists once funded very early-stage companies, but now almost all want to see a business that is up and running before they jump in.

As a company grows, it may have the option to raise repeated ‘rounds’ of venture funding, selling more and more of the company in exchange for (hopefully) bigger slugs of cash. But at some point, VC money runs out. At that point, the best option is for your company to be on the road to an acquisition at a great multiplier or, very rarely, an initial public offering.

But most companies don’t get VC funding. There are plenty of good reasons for this.

  • Maybe they never thought they needed it
  • Maybe they’re in an industry that VCs don’t favor.
  • Maybe they never thought they’d have explosive growth in the relatively short time frame that VCs require
  • Maybe they tried to get VC and were turned down.

These companies may start out with a bank loan. As they grow, a revolving line of credit gives them the cushion they need for working capital. Years down the road, the company may have tens of millions in revenue. They see opportunity, but they don’t have the cash flow to finance it. They may not want the burden of a bank loan, especially when the company itself may be worth quite a bit.

You meet these CEOs at growth-company conferences. Ask them what their company does, and you’ll get the quick pitch. Then a pause. Then, “We need an equity partner.”

The "Good" Private Equity

At this stage, private equity is generally not the same beast you’re hearing the Republican presidential candidates complain about. Just as in venture capital deals, the entrepreneur sells some equity in his or her company to a private equity investor in exchange for cash, a board seat and some management expertise. And just like venture capitalists, the private equity investors are going to need some way to get their money out of the company at some point, which will eventually mean a sale.

If you don’t find much to hate here, you’re in good company. That’s because when people throw around the term private equity, they’re generally referring to the huge buyout shops like Blackstone Group, Kohlberg Kravis Roberts, and yes, Bain.  The stated aim of these investors is to buy controlling shares of companies that are undervalued or struggling, turn them around, and reap the rewards.

A recent study of 3,200 private equity deals between 1980 and 2005 found that overall, companies with private equity investments saw net job loss of just one percent, compared with similar companies that didn't have private equity investments. But the results are not at all uniform. Among companies that were public and then are taken private, the job losses are disproportionately large.

Private equity is dicey business, and when a company that’s taken private equity fails, it’s sometimes hard to know whose fault it is. After all, the investors wouldn’t have been interested in the first place if the company had been a lean, mean, fighting machine.

But there’s a reason the huge private equity shops have been referred to as “barbarians at the gate.” In some private equity deals, the equity investor buys control of the company, cuts lots of jobs, and loads the new ‘healthier’ company with a ton of debt. Then they pay themselves huge management fees, and sometimes manage to cash out before the company turns around. That leaves other shareholders to suffer if the company doesn’t make it. 

That type of behavior, as Mitt Romney is finding out, is generally thought to make for a poor President.

Published on: Jan 12, 2012