I wish I knew what private equity was, but I’m too embarrassed to ask

Private equity simply refers to an ownership stake in a company that is not publicly listed. Private-equity investors (usually backed by big institutions, although there are also listed private-equity funds that small investors can buy easily) either invest in unlisted companies, or buy listed companies – typically ones that are seen to be underperforming – and take them private.

Private-equity managers aim to be very hands-on owners, unlike traditional shareholders in listed companies. By working with unlisted (or de-listed) companies, the private-equity owner escapes the short-term focus of the equity markets. In theory, this gives them the space and time needed to make the companies more efficient (if the firm is a “turnaround” play) or to “unlock its true value” by pursuing a longer-term or more radical strategy than public shareholders might be expected to tolerate. Having whipped the company into shape, the private-equity manager will then seek an “exit” – often by relisting the company on public markets.

This is a time-consuming process, so investors should expect to have to lock up their money for several years. Tying up your cash in an asset whose true value is never entirely clear (much like a house, you only know what an unlisted company is really worth when you try to sell it) is risky. The reward investors expect to achieve for taking this extra risk is known as the “illiquidity premium”.

Theory and reality do not always match up. Sometimes private-equity owners do improve a company – but private equity is also often criticised for being more about financial engineering. The new owner borrows lots of money against the firm’s assets; slashes investment spending (damaging longterm growth prospects) to pay the interest; and then “flips” the hollowed-out company along with the enlarged debt load, making a handsome return on the thin sliver of equity it initially provided.