They engineer deals to generate multiple revenue streams, no matter how the business performs.
When it comes time to consider selling our company, turning to a private equity buyer is often an attractive option—especially when they’re willing to pay more than a strategic buyer would.
But have you ever wondered how private equity firms make their money?
The answer is that private equity firms are run by super-smart people who have built multiple revenue-generating streams into their businesses. Many of those streams are independent of business performance. Let’s look at some of the biggest ones.
1. Buying Low; Selling High
Private equity firms primarily generate revenue by buying companies at low prices and selling them at higher prices. They profit from the price difference. They accomplish this in various ways, starting with their negotiation skills. They approach negotiations by minimizing risks when agreeing on a price—ideally at or even below market value. Inexpensive companies can be hard to find, especially when many cash-rich firms compete for a limited number of deals.
However, those savvy negotiating skills are also used to ensure that the private equity company seeks to sell the business for as high a premium as possible when it comes time to sell.
2. Financial Efficiency
When private equity firms seek deals, they prefer to target companies with strong balance sheets, substantial inventory, and ample receivables. They also look for companies that are not efficient with their cash. This is because a private equity buyer will quickly begin extracting as much money as possible from the business, for instance, by withdrawing cash from the balance sheet and distributing it to investors.
The private equity firm will also improve the business’s operational efficiency, generating more cash that can later be extracted through higher dividends. These operational enhancements will further help to increase the company’s value when it comes time to negotiate a selling price.
3. Management Fees
When you sell to a private equity firm, part of the deal structure is that the new investors will have a direct say in how the company is run. They expect to be compensated for this, which might take the form of board fees or other financial payments.
4. Taking on Debt
Many entrepreneurs are cautious about debt, while private equity firms tend to embrace it. This move is because they use debt to minimize the amount of cash required for a deal. Leveraging debt to acquire a company significantly enhances the rate of return they achieve when they eventually sell the business. For instance, if you buy a company for $10 million and sell it for $20 million, your return on that sale is 100%. However, if you structure the deal so that half of the purchase price (let’s say $5 million) is financed through debt, you can effectively double your return to 200%.
This is critically important for investors because they typically take 20% of the profits from any business sale as a success fee. In other words, the more private equity firms can enhance the rate of return by leveraging debt when selling the business, the more they can earn at the time of the sale.
In some cases, private equity owners will add debt to a performing business and then use the cash infusion to pay themselves a healthy dividend. I have seen instances where a private equity firm withdraws its entire initial investment through debt-driven distributions. This is known as “PE Heaven” because returns are essentially infinite once there’s no cash in the deal.
5. Investor Fees
So far, I’ve explained how private equity firms profit from the companies they buy and sell. However, it’s also important to recognize that private equity firms generate income from the investors from whom they raise funds, typically around 2% annually. The money collected from these fees usually covers the basic costs of their operations; it’s not what allows them to afford their private planes and yachts. It’s worth noting that investors expect results when they pay fees like these. They don’t like paying a fee for the money to sit idle. This helps explain why private equity firms operate like sharks, constantly moving to seek out new deals to make, sometimes overpaying to show progress to their investors.
Playing the House
When you consider all the different ways private equity firms generate profits, it may seem unjust. They are designed to maximize every deal they strike, ensuring they come out on top. In many respects, they resemble the house in a casino. And, as we all know, the house always wins in the end.
