How Does Private Equity Actually Work

What do Legoland, The Hilton Hotel, and Ancestry. com have in common? Well, they're all owned by the same company, Blackstone, the biggest private equity firm in the world.

Private equity is one of the most powerful forces in finance. Yet, most people don't fully understand how it works. You see, any kind of company needs money to grow fast.

And there are two ways for them to get that money. First, they could sell shares to the public. That's you and me.

Second, they could sell pieces of the company to private investors. That's private equity. And there's more to this.

When a private equity firm buys a company, they've got no intention of holding on to it and pocketing the profits. Instead, they buy it with the intention to sell it as soon as it makes sense. So, what exactly is private equity?

Where did it come from? And how are people getting so rich from it? Well, let's dive in.

Welcome to Alux, the place where future billionaires come to get inspired. So, private equity is a way for big investors to buy companies, make them better, and sell them for a profit. And these firms work with four key steps.

Step one is to raise money from outside investors and put it into a special fund. Step two is to use that fund to buy companies. And step three, to make the companies profitable.

Once they own the company, they'll go in and restructure it so they can increase profits. So they might bring in new leadership, lay off workers, open up new locations, or make the marketing and branding better. Sometimes these changes lead to huge success stories.

And sometimes they backfire. And then there's step four, sell them for a profit. After 5 or 10 years, the firm sells the company in one of three ways.

Either through an IPO where it becomes publicly traded again, or they sell it to another company, or they sell to another private equity firm. If everything goes as planned, they sell it for much more than what they paid, and the firm and its investors make a massive profit. So, private equity has been shaping all industries for over a century now.

But it didn't start off with this four-step strategy. In the early 1900s, business tycoons like JP Morgan, the Rockefellers, and the Vanderbilts were already making deals where they bought companies with investor money instead of just their own. But the big difference is that they didn't flip these companies for a profit.

No, instead they bought multiple companies in the same industry, merged them to form massive corporations, and then used that to build their empire. Kind of like in Monopoly where you build your empire by first building up the same color pieces of land and after that you can build your houses and only when you have enough houses can you build that hotel. Well, back then the empire took a lot longer to build.

All of this changed though after World War II. The economy was booming and hundreds of thousands of veterans were returning home. Investors saw this as a golden opportunity for the rise of new businesses.

So, George Doy, a Harvard professor, created the American Research and Development Corporation or ARDC back in 1946, the first real venture capital firm. And his biggest bet was on a tiny company called Digital Equipment Corporation or DEEC. Now, ARDC invested just $70,000.

And when DEC went public in 1968, that investment was worth $355 million. Deoit proved that private investors could back innovative companies before they made it big. He set the stage for venture capital.

By the 1980s, private equity had transformed yet again. This time, it went from betting on new ideas to taking on existing companies and making them profitable. Some deals paid off while others led to spectacular failures and bankruptcies.

But one thing was clear. Private equity was now a major force in the financial world. As private equity became more mainstream in the 1990s and early 2000s, it wasn't just billionaires playing the game anymore.

Pension funds, university endowments, even governments started pouring money into private equity firms. After the 2008 financial crisis, regulations got tighter. So instead of just slashing costs, they focused on improving operations, bringing in better management, and using technology to increase profits.

By the 2010s, private equity was stronger than ever. Today, firms like Blackstone, Carlilele, and Apollo manage trillions of dollars, and their influence extends into nearly every industry, including real estate, credit markets, and infrastructure. And this evolution of private equity also shows us the different strategies that modern firms now use.

So, let's talk about these different types of private equity, shall we? So JP Morgan's 1901 acquisition of Carnegie Steel is considered the first major leveraged buyout or LBO, which is the most well-known type of private equity. So an LBO is when an investor or private equity firm buys a company using money pulled from other investors, which is exactly how JP Morgan raised capital back then.

Now, modern LBOs work a little bit differently. The firms raise money from investors just like JP did, but they also borrow a lot of it and they use the target company's assets to leverage the debt. So, here's how that works.

Imagine you work for an investment bank and somebody comes to you with a loan request. They tell you that they need to borrow a lot of money to buy a whole other company, make that company very profitable, and then sell it. and they tell you that instead of borrowing against their own assets, the loan will be backed up by the acquired company's assets and future earnings.

This way, if the investment fails, you can recoup that loss from their assets. But even better, if it's successful, you can make a lot of money. It's high risk, which means you can charge high interest rates.

The debt is secured against real assets, so you won't face a total loss. and the potential returns are massive. Now, these kinds of firms, the ones that specialize in LBOs, are experts at what they do.

They have a history of successfully restructuring companies. In 2007, when Blackstone Group acquired Hilton Hotels for $26 billion, one of the first things they did was appoint a new CEO. Then they moved the company away from ownership in real estate and focused instead on making it a brand management and franchising company.

They injected $800 million into it to boost the company's financial health. This allowed them to get bigger loans and then they used that money to renovate, market, and expand their locations. When Hilton went public again in December 2013, its stock closed at $21.

50 a share. Over the next few years, Blackstone gradually sold its stake. By 2018, they fully exited their investment, making around $14 billion in profit over 11 years.

Now, that is a leveraged buyout success story. But not all deals pay off that well. You remember Toys R Us?

Well, their story is probably the most popular botched buyout of our time. In 2005, multiple private equity firms joined forces and bought the company for about $6. 6 billion.

Because the deal was structured as a leveraged buyout, they financed the deal with Toys R Us assets and future earnings. All of that debt was placed on the toy sellers balance sheet, just like what was done with the Hilton. But these investors missed a few key things in the Hilton deal.

Blackstone injected that $800 million into the company. There was no kind of cash injections for the Toys R Us deal. Instead, between 2005 and 2017, the firms actually collected more than $470 million in fees and interest from the company.

So, with the massive debt and extra fees and interest, the company didn't have the money to invest in improving its stores and upgrading to e-commerce. So, it fell behind the competition. 12 years after the acquisition, with no way to service its debt, the company filed for bankruptcy.

More than 800 stores closed down and thousands of people lost their jobs. It's cases like this that have brought criticism and controversy to private equity firms. But it's not all like this.

In fact, LBOS's are a very different strategy to the one George Doit used when he set that stage for venture capital. Now, we say set the stage because his most famous investment, the DEEC one we mentioned earlier, was actually a strategy known as growth equity. So, growth equity is like the more reliable, sensible cousin of venture capital.

It's where firms invest in established fast growing businesses that need capital to expand. So these companies are already profitable, but they need funding to scale their operations, enter new markets, or develop new products. Unlike LBOs, these deals use little to no debt, and private equity firms usually buy a minority stake instead of taking full control.

This is exactly how Tik Tok was able to get such a global reach. Two firms, General Atlantic and KKR, invested in Bite Dance, Tik Tok's parent company, which gave them the funds and resources to scale their operations quickly. Whereas venture capital is the high-risk, highreward side of investing.

This is where the firm pours money into small, unproven startups and hopes they'll turn into billion-dollar companies. It's all about betting on new ideas and early stage companies before they've proven themselves. If the startup succeeds, the investors can make massive returns.

If it fails, well, they can lose everything they invested. If you work for a startup or you're up to date in Silicon Valley news, then these are the firms that you'll know well. Think Sequoia, the firm that invested early in Airbnb, Google, and WhatsApp.

or Andre and Horowits, the firm that invested in Skype, Facebook, and Twitter. Not all deals go that well, though. Seoia also invested $214 million in the cryptocurrency exchange FTX when the company collapsed in 2023.

Seoia lost all of that. Venture capitalists also invested $700 million in Theronos, only to lose it all when the technology was found to be fake. Now, the last main strategy is one that generates all of the controversy, and we first saw it during that shift in private equity back in the 70s.

It's called distressed investing. So, distressed investing is when firms buy struggling or bankrupt companies on a discount and then try to turn them around for profit. Sometimes this means fixing operations and making the company profitable again.

Like when the firm Up Capita bought Game UK, they did a massive restructuring and within 2 years increased the company's market value to more than 12 times what they paid for it. But other times they cut costs so aggressively and sold off so many assets that they left the company worse off than before. One of the first examples of this was in 1969 when a man named Victor Posner who owned DWG Corporation executed a hostile takeover of Sharon Steel.

He got the company at a discount and started working on restructuring it to make it more profitable. In 1987, Sharon Steel filed for bankruptcy. Despite so many companies going bankrupt, in 2024 alone, 110 companies backed by private equity ended up filing for bankruptcy.

So despite that, private equity has turned investors into billionaires and built some of the biggest financial empires in history. But how exactly does it make people rich? How are these private equity firms making so much money?

Well, it's all in the way the deals are structured. From just one deal, the firm is able to create multiple income streams. They're not liable to pay back the loan they've taken out, and they only contribute about 10% of their own money to the fund.

Now, for the multiple income streams, they don't wait until the final sale to make money. They charge their investors management fees, usually 2% of the total assets that they manage, and performance fees, which is 20% of profits. Even if a deal struggles, they still collect millions, even billions in fees just for managing the fund.

Then their exit strategy pushes for maximum profit. They don't just sell the company to the highest bidder. They look for the deal that's going to make them the most money.

That could mean going public, selling it to a competitor, or flipping it to another firm for more restructuring. And they make sure they time their exits for when valuations are highest. If they restructure the business, increase its profitability, and sell it for $20 billion a few years later.

They don't just double their money, they make 10 times their original investment. Then there's the debt. The acquired company is the one that has to pay the loan and the interest on that loan is taxdeductible.

So the business can keep more of its earnings. And since they only contributed a fraction of the purchase price in actual cash, their return on investment isn't just a 2x gain, it could be 5 or 10x. And that's how you end up with companies like Blackstone, KKR, and Apollo.

private equity firms that manage trillions of dollars and own hotels, media companies, and tech companies. Basically, they own the world, and they're going to keep getting richer and more powerful. And you know, there's so much to unpack here that we've barely scratched the surface.

So, we knew we had to take this further, which is why we're partnering with founder, entrepreneur, and speaker Aram Tagavi. Aram has started multiple successful businesses. And along the way, he realized just how much money he could make if he bought existing businesses.

So, coming soon to the Alux app, Aram has put together an exclusive collection all about the private equity game. You'll learn how to get started buying businesses, even if you don't have capital, how to network and make deals with other people's money, how to negotiate, and so much more. The countdown is on.

So to keep an eye out for Aram's collection, sign up to the Alux app today. Even better if you downloaded and scan this QR code on screen. You'll get 25% off the annual membership, and I'll be right there with you every step of the way.

Okay, let's jump into the comments section together, shall we? What do you think is the future of private equity? Is this something you'd like to get involved with, or are you happy just to learn about it from a distance?

Let's chat. We'll see you back here next time, Alexir. Until then, take care.