Private equity explained: buyouts, returns, controversies

A fund raises one billion from investors, borrows three billion more, then buys a company for four billion. The debt lands on the books of the acquired company, not on the fund's. If everything goes well, this structure turns a modest stake into a spectacular profit. If everything goes wrong, it is usually the acquired company that collapses, rarely the fund. This mechanism has a name: the leveraged buyout. It sits at the heart of an industry that now manages trillions and owns businesses employing tens of millions of people across every continent.

Private equity draws two opposite stories. To some, it creates value by waking up sleepy companies. To others, it loads healthy businesses with debt before draining them. Both stories are true, depending on the case. Understanding why requires taking the mechanism apart, figure by figure.

The basics: buy, transform, sell

Private equity means buying stakes in companies that are not listed on a stock exchange. Unlike a shareholder who buys an Apple share in seconds, a private equity fund takes control of an entire company, holds it for several years, then sells it. The model rests on three steps: raise capital, acquire and transform companies, sell at a gain.

The capital comes from institutional investors: pension funds, insurers, sovereign wealth funds, wealthy families. These investors, called limited partners, entrust their money to a management firm for a typical span of ten years. The management firm, called the general partner, decides alone which companies to buy. It earns money in two ways: an annual management fee, often 2 percent of the sums managed, and a share of the profits, often 20 percent above a minimum return. This profit share has a famous name in finance: carried interest.

The leveraged buyout, engine of the model

The most common and most debated form is the leveraged buyout, or LBO. The principle: finance the purchase of a company mostly with debt rather than with the fund's own money. A simplified example makes the mechanics clear. A fund buys a company for 100, putting in 30 of its own capital and 70 borrowed. Five years later it sells for 150 after repaying part of the debt. Once the debt is cleared, the gain flows to the fund. Its stake of 30 may have doubled or tripled, even though the company's value rose only by half. That is leverage: debt amplifies the return on equity.

This leverage cuts both ways. If the company loses value or struggles to repay, the losses are amplified just the same. And because the debt sits on the acquired company, it is that company's results, workers and suppliers that feel the consequences first. This is why the same tool can produce exceptional returns and dramatic bankruptcies.

An industry born in the 1980s

Modern private equity has a symbolic birthdate: 1988. That year, the fund KKR bought the American food and tobacco giant RJR Nabisco for roughly 25 billion dollars, the largest corporate control deal ever at the time. The book and film Barbarians at the Gate turned it into the symbol of an aggressive, conquering brand of finance. The industry has since changed scale. What was a niche practice became an unavoidable asset class, present from New York to Singapore.