in July of 2019 Elizabeth Warren said this Sears private equity toys-r-us Gymboree and it's not just retailers her argument is that private equity is to blame for the closing of some of the biggest household name retailers shop Co Toys R Us Sears in Gymboree whether or not this is just strategic messaging for her presidential campaign or if she genuinely believes it her claims deserve a deeper look what is private equity how does private equity make money and are they responsible for these retailers going bankrupt you're watching a compounded daily video if you like this video
subscribe to our channel and hit that notification bell when you think of Wall Street you think of big banks hedge funds trading floors and maybe Gordon Gekko or Jordan Belfort but the chance that you have heard about private equity if you are unfamiliar with Finance is pretty slim and there is a reason for that if you are not in the center of a global economic crisis crafting ways to get large returns or having insane parties in your office after a successful year then it's likely that the media doesn't care about you and private equity fits
that box the simplest way to describe private equity is the use of funds to purchase ownership and other companies much like buying stock on the stock market private equity firms will buy a majority or minority stake in a private company however it's most likely that they will purchase a majority stake for one reason control of decision-making in the company this is key as private equity groups who purchase these companies have investors and if they purchase a minority stake of the company then the majority shareholders could implement poor leadership and the money they invested in the
company could be lost the structure of private equity funds goes like this they are usually structured as limited partnerships with a general partner putting up a small minority of the capital invested typically around 3% the limited partners therefore contribute a majority of the capital and the size of these buyout funds averages around 600 million to 800 million dollars in the past year however the average fund size has increased to almost 1 billion dollars that's right these funds spend hundreds of millions if not billions to buy companies now you're probably thinking that these investors are deep
pocketed individuals who have access to money that us regular people do not right well not exactly emitted Li some investors in these funds are wealthy individuals but most of this money comes from pension funds labor unions university endowments and other qualified investors the reason why private equity funds are such an attractive investment opportunity is because of their rather high returns it's common that private equity funds will beat the S&P 500 making it an attractive investment vehicle for those with the means to invest in them usually these funds can return anywhere from 15 to 25 percent
but how they do sell is what makes them so interesting imagine you are going to buy a house you pay for 15% of it in a down payment and the rest is paid through a mortgage you don't plan on using this house so you rent it out and the amount you charge on rent is enough to pay the property tax utilities and the mortgage itself so what's the point well you are effectively gaining ownership in the house at the expense of the lessee when they pay rent they are paying for you to own the house
the principle in private equity is the same when these funds raise money that money is typically only purchasing a part of the company they are trying to buy you can think of it as a down payment fund but usually 40 to 50 percent of it is paid for with the money the fund has raised the rest is paid for using leverage which is a fancy term for debt and knowing that they mostly target profitable companies means that they could use some of the money that would have gone towards its profitability to pay down that debt
so if I were to buy a company that had two million in profits for the price of ten million dollars with six million in debt and four million in cash then I could use that two million to pay down the 6 million in debt over three years after I pay down that debt I could sell the company for ten million dollars even if I did nothing to grow the company and earn a six million dollar profit this is the idea of a leveraged buyout and it's what helps these funds yield such high returns private equity
does in fact actively try to grow the companies that purchases allowing for it to sell the company for more than it purchased it to maximize its returns they do this through two methods the first is organic growth such as marketing and hiring a sales team to expand the products user base private equity groups will use their majority shareholder power to hire executives who they believe will operate the companies in a way to maximize the funds return the second method in growing these companies is by similar companies through more leveraged buyouts let's say that company a
is a software company offering social media marketing tools and the private equity ownership decides to buy Company B which is similar size for the same price for this example 10 million dollars assuming that Company A's debt has already been paid down they borrow a new five million dollars on company a and Company B borrows five million all of this is borrowed money allowing for the private equity groups to expand the size of these companies without spending a nickel out of their fund they would then pay down the debt with the combined company's profitability allowing them
to effectively increase the value of their combined company at no expense to the fund so now that you know a little about private equity ask yourself is private equity at fault for these large retailers going bankrupt the answer is obvious what incentives would they have for bringing down companies defaulting on buyout debt and ultimately losing the trust from their front investors there isn't private equity has no incentive to bring companies anywhere but upwards and the strategy when purchasing those large retailers was to try to turn them around and bring them back to profitability so why
did these companies go bankrupt former toys are a CEO Gerald Storch responded to Elizabeth Warren's comments by saying this the internet e-commerce and Amazon that's what is killing these retailers private equity is the unlikely villain in this case rather convenient shopping in Amazon have made it hard for these retailers to survive thanks for watching if you like this video make sure to give us a thumbs up [Music]
