Most businesses use a well-defined stream of cash to define profits and losses. Metrics are established to track the various revenue streams and this allows a business to eventually meet its budgetary goals. In the private equity business model, profits and success comes from various investments instead of direct activities performed or sales rendered.
What is unique about this particular business model is the fact that it is not uncommon for there to be billions of dollars in play at any given time. Most of these assets are directed toward investments into other companies and entities, however, which means the actual assets that are on-hand are typically negligible.
So how does the private equity business model make money?
- Through the amount of carried interest that occurs on the investments.
- By accumulating dividend payments from certain investments.
- By charging fees to investors who decide to place money with the organization.
Where private equity places a point of emphasis is with a portfolio company that is value priced today, but could be working in an industry where the potential for future profits are very high. The idea isn’t to turn around a failing company to make it profitable again. It is to find an already profitable company and make it more profitable… or to break it up into pieces to sell it.
The Private Equity Business Model Is Powered By Fees
The most reliable method of making money with this business model is to charge fees. There is typically a 2% management fee that is applied to any committed capital investments. One could call it a “privilege fee” for being able to invest with a particular firm. In the modern private equity business model, however, this fee is being waived so that money gets directly placed into the investment fund so that revenues come at the current capital gains rate.
There is also a 1% transaction fee of the amount that is being investment. This typically comes from portfolio companies, but could come from the investor as well. There are also monitoring fees, advisory fees, and potentially consulting costs that are also tacked onto the portfolio of the private equity business.
Carried Interest Is a Share of the Capital Gains
The private equity business model also makes money through the practice of carried interest. This is the share of the capital gains that get generated by the fund itself. It means profits are being made on the portfolio investments. This can happen by taking a company public, deciding to sell the company, or to recapitalize dividends that have been generated.
In order for carried interest to be taken as a profit, an established rate of return must first be achieved. This is called the “hurdle rate” and the average rate set is about 8%. When the hurdle rate is achieved, most private equity businesses can receive up to one-fifth of the carried interest that has been achieved. After a history of success, more negotiating leverage can be obtained to take a greater percentage of the carried interest. The hurdle rate can also be reduced or eliminated. This is generally the field where the most revenues are generated by this business model.
Dividends Can Pay In Certain Circumstances
This part of the private equity business model relies on the profits that are paid back to shareholders from portfolio investments. When there is a certain amount of equity held in a firm and a dividend is paid, this dividend is a reflection of the equity percentage. If a total equity payment of $5 million is authorized and a firm owns 10% equity, then the total dividend received would be around $500,000.
Although many private equity firms aren’t investing into companies that are already publicly held because dividend percentages are typically low, below 5%, some have started to look at this method as a supplemental income option. The practice is the same as it would be with the private investor. Shares are purchased, an equity percentage is achieved as a result, and dividends are paid on a schedule dictated by the company.
The private equity business model is not for every business. Most corporations, especially small businesses, will do better using a more traditional business model that tracks overall profits and losses through actionable items. For those organizations that do have access to capital and have a network which can help them recruit more of it, then this is a business model that may make sense.