The Back Door Way Ordinary Investors Can Profit from Private Equity Firms

Private equity firms are replacing hedge funds as Wall Street’s glitziest way to make a fortune, and you can get your share

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Private equity funds typically control a company — unlike hedge funds and mutual funds, which normally just buy up a lot of shares of a company they like.

In fact, PE funds prefer to find companies they believe are underperforming their potential.

Once they find such a company, the PE fund doesn’t just buy shares — it takes the company over. Frequently, it fires the current management team and installs its own, making changes it believes will grow the business.

In a way, that sounds a lot like corporate raiders, such as Gordon Gecko in the movie WALL STREET. They buy a company worth more with its pieces sold off than as a functioning entity — and then sell off the pieces, pocketing the profits despite destroying the company.

Actually, though, PE funds are the opposite. They buy the company lock, stock and barrel to improve the its performance — not to destroy it.

If the company they buy is a publicly traded company, the PE fund delists it. They don’t want to divide the profits with ordinary shareholders.

The PE funds generally have a much longer timeline than hedge funds.

Hedge funds will hope to sell stock shares at a profit within a few months. PE funds will hold for 5 to 7 years.

At that point, they plan to sell to a private buyer or to relist the company back on a stock exchange.

Clearly, PE firms play a far more active role in achieving business results than ordinary “investing” implies. They’re not trying to catch and ride a trend — they actively create or accelerate the trend.

Warren Buffett has done this to a certain extent. Berkshire Hathaway wholly owns See’s Candies, Geico, Duracell, Dairy Queen, Fruit of the Loom, Helzberg Diamonds and other companies.

However, Buffett’s style is quite different than most private equity firms. When he looks at businesses, he looks for good management teams instead of underperforming ones. When he took over Berkshire Hathaway, he did immediately fire its CEO, but that’s the exception. He has fired people who disappointed him, but it’s not his standard Method of Operation.

Also, he buys entire companies with the same basic philosophy as he does shares of Coca-Cola and Gillette. His favorite holding time is “forever.” For instance, he’s made an 8,000% return on See’s Candies since buying it in 1972.

Private equity is not infallible. Toys R Us is probably its best known failure. Despite being taken private by KKR, Vornado Real Estate and Bain Capital, the toy company could not pay off its massive debt.

In addition to the expected huge profit upon exiting the deal by selling the company, private equity firms receive ongoing cash in the form of management fees. Typically, these are 1.5% to 2.5% of the total capital committed to the fund.

However, it takes a lot of money to participate in these deals — and you need plenty of experience and a great reputation in business.

It might seem contradictory, but many companies that participate in private equity deals are themselves publicly traded.

That is, you can just buy their stock.

The key to many successful business deals is cash flow.

Investors with hundreds of thousands of dollars are nice.

But companies can raise even more money from the masses of investors who can put in only a few thousand dollars.

1. They manage private equity funds — collecting management and performance fees.

Examples: Kohlberg Kravis Roberts & Co. L.P. (KKR), The Blackstone Group L.P. (BX), and Oaktree Capital Group, LLC (OAK)

2. They invest their money into private equity deals

Examples: Wendel SA (MF FP), Exor SpA (EXO IM) and Reinet Investments SCA (REI SJ)

3. They invest in private equity deals

Examples: Ares Management (NYSE:ARES), Main Street Capital (NYSE: MAIN), Gladstone Capital Corp (NASDAQ: GLAD) and Prospect Capital Corp. (PSEC)

NOTE: These are examples only, NOT recommendations. You must carry out your own due diligence.

Special Purpose Acquisition Companies are a different model, but they do allow ordinary investors to leverage the specialized knowledge, experience and connections of highly successful entrepreneurs.

A highly reputable and successful entrepreneur launches a company, the SPAC. The price is $10 per share — which is standard.

For a year or two, the SPAC is essentially a shell company — the entrepreneur, and your money sitting in a bank account.

Then the entrepreneur finds a high-quality company, and buys it.

This is now possible because it’s difficult for mid-sized companies to launch IPOs. They need a Wall Street investment bank, but Goldman Sachs is only interested in $10 billion deals.

If your company is worth only $200 million, it’s beneath Wall Street’s notice — even if you’re a highly profitable business that could grow tremendously with enough capital.

So the SPAC simply buys up the too-small-to-matter-to-Goldman company. It’s now publicly traded, and will (hopefully) grow into a huge national success.

Which means your shares will grow tremendously in market value.

Success with private equity investing and with SPACs requires a good business.

There’s no magic. Don’t risk your money on dogs.

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