Got A Question For The 'Masters of the Universe'? : Planet Money What is private equity?
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Got A Question For The 'Masters of the Universe'?

Tomorrow, I'll be in Philadelphia at the Wharton Private Equity Conference. I'd like to invite you to post or e-mail questions or issues you would like me to cover while I'm there. If you're wondering what private equity is, click on the jump.

"Equity" refers to a stake in a particular company; in return for their investment, holders receive partial ownership in the form of a stock. These investors get to vote on corporate policies and elect members of the board — their influence is proportional to the percentage of the company they own. Let's look at public equity first.

Most stock investments that appear in the news refer to public equity, which you and I can buy and sell on exchanges such as NASDAQ or the New York Stock Exchange. Companies that have shares traded on these markets are known as public companies; the federal government requires them to disclose earnings, major corporate decisions (such as the hiring and firing of senior officers) and the value of their assets and debts.

It's easy to figure out the value of public equity — just multiply the current stock price by the number of shares outstanding; the product is known as the market capitalization (this information is readily available at Google or Yahoo! Finance). The portion of the company owned by a shareholder is a function of the number of shares overall, or "outstanding"; in other words, if you bought one share of UPS, for example, you would become the legal owner of one-billionth of the company.

Ownership of one of a billion shares does not give you much power; by purchasing a small number you essentially place the fate of your investment in the hands of shareholders who own millions of shares. Although you can still cast your ballot, owners of large portions of the company are generally the only ones truly capable of swaying the results. In the case of public equity, investors will typically own no more than 5 or 10 percent of a company.

On the other hand, private equity investors go for the whole enchilada. These investors believe that public shareholders either don't know enough or don't care enough to govern the company properly; I'd imagine that most have memorized the famous speech by Gordon Gekko, the villain of the movie "Wall Street" who has become an inspiration for a generation of investors.

By consolidating ownership, these investors believe they can eliminate the inefficiencies that have been tolerated by public shareholders. Once ownership is established, the private equity firm can force the company's leadership to undertake what are often radical changes, such as selling divisions and renegotiating contracts. The objective of the private equity firm is to buy a company whose shares have become undervalued, turn it around in the span of a few years, and then sell new shares back to the public markets at a (hopefully) higher price.

In order to gain total control, a private equity investor must buy all of the outstanding shares of a company (this transaction is known as a "buyout"). This is no easy task — the largest transactions involve billions of dollars. In order to get this kind of capital, private equity firms must borrow money, using as collateral the assets of the company they're buying, achieving what is known as "leveraged buyout."

Just as in physics, leverage is an extremely powerful investment tool, available only to funds that can bring millions or billions of their own dollars to the table. However, the debt involved is also dangerous. The amount a private equity firm will borrow to buy a company typically far exceeds what the firm itself is worth. However, the firm is obligated to repay the debt whether or not the acquired company makes them any money. For example, Apollo Management, which bought houseware retailer Linens 'n Things in February 2006 for $1.3 billion. As Linens slid into Chapter 7 bankruptcy, Apollo was forced to assume responsibility for all of the debt.

With analysts calling 2008 private equity's Year from Hell, I look forward to see how fund managers will pick themselves up in 2009 and plan for the future.