What Is Private Equity?
Private equity firms buy struggling companies, help them improve, then resell them for a profit. Unlike consulting firms, who seek to make money by charging fees to corporations for advice about how they could improve, private equity seeks to control companies instead of merely collaborating with them. This makes some turnaround strategies available that are not possible with a consulting firm. For instance, firing executives is usually an essential part of fixing a failing company, but consulting firms don’t have the power to fire the people who have hired them. Because private equity faces fewer obstacles to turning around companies, they have higher success rates and more profits to share with investors.
Private Equity Compensation
Lots of attention has been focused on private equity with the presidential candidacy of Mitt Romney, who founded the private equity firm Bain Capital and made nearly $200 million as its owner. Most private equity firms have partners or principals: owners who also have a managing role in the firm. Instead of giving stock options or huge salaries to its top executives, private equity firms often just share their profits with its partners. For this reason, most private equity firms are privately owned by the individuals who run them.
The share of the profits is determined both by the partners’ seniority and the amount of their own money that they contribute to the deal. Partners with high net worths could contribute a significant portion of the money needed to buy a company, and as a result they would earn an equally large portion of the profits. It should be noted, however, that their risk is greater as well. If a company flops while they own it and sells for less than it was purchased for, the partners lose their own money.
With Great Risk Comes Great Reward
Because partners at private equity firms have so much risk exposure in their deals, their compensation packages are ordinarily worth millions of dollars, if not tens of millions. Some deals are paid off with stocks from the purchasing company, which partners can sell immediately and pay the 35 percent short-term capital gains tax or save for two years and pay the 15 percent long-term capital gains tax. The lower tax rate on long-term capital gains helps many partners pay lower tax rates than they would if their compensation were taxed as earned income.