Is Private Equity Buy-Side or Sell-Side?
Clarify private equity's position in finance. This article explains its core buy-side function and how it acquires and builds companies.
The financial industry is broadly divided into two main functions: the ‘buy side’ and the ‘sell side.’ Understanding these distinct roles clarifies how different entities operate and interact within the broader economic system.
Understanding the Buy Side
The “buy side” refers to institutions and professionals primarily focused on managing assets and making investment decisions for their clients or their own portfolios. Their main objective involves deploying capital to acquire securities or other assets with the expectation of generating returns. These entities engage in extensive research, analysis, and due diligence to identify suitable investment opportunities that align with their specific strategies and risk tolerances.
Entities commonly found on the buy side include asset management firms, mutual funds, hedge funds, pension funds, and university endowments. These organizations pool capital from various sources and then invest it across different markets, such as equities, fixed income, real estate, and alternative investments. Their activities contrast with the “sell side,” which typically involves investment banks and brokerages that facilitate transactions, issue securities, and provide research and trading services to investors.
Understanding Private Equity
Private equity represents an alternative investment class characterized by direct investments in private companies or the acquisition of public companies that are then delisted from public stock exchanges. This investment approach often involves taking a controlling interest, allowing for significant influence over the acquired company’s operations and strategic direction. The goal is to enhance the company’s value over a holding period, typically between three to seven years, before eventually selling it for a profit.
Private equity firms are structured with general partners (GPs) and limited partners (LPs). General partners manage the funds, identify investment opportunities, and oversee portfolio companies, receiving management fees, often around 2% of assets under management, and a share of the profits, known as carried interest, commonly 20%. Limited partners are the investors who commit capital to the funds, such as pension funds, endowments, insurance companies, and high-net-worth individuals, seeking higher returns than traditional investments. These funds typically have a finite life, often around 10 to 12 years, during which investments are made, nurtured, and ultimately exited.
Private Equity’s Buy-Side Function
Private equity firms operate squarely on the “buy side” of the financial industry. Their primary activity involves identifying, evaluating, and acquiring target companies for their investment portfolios. This process begins with extensive market research and proprietary deal sourcing to uncover businesses that fit their specific investment criteria and have potential for operational improvement or growth. Their focus is on purchasing entire companies or significant stakes in them, rather than simply trading securities.
The acquisition process for private equity firms is rigorous, involving detailed due diligence that spans financial, legal, operational, and commercial aspects of the target company. Valuation methodologies, such as discounted cash flow analysis or comparable company analysis, are employed to determine an appropriate purchase price. Deal structuring is another core buy-side function, where private equity firms arrange the capital stack, often combining a substantial amount of debt financing with equity contributions from their funds to complete the acquisition.
Key Private Equity Investment Strategies
Private equity firms employ various investment strategies, all of which exemplify their buy-side function through the acquisition of companies or significant stakes. Leveraged buyouts (LBOs) are a prominent strategy where a private equity firm acquires a company using a substantial amount of borrowed money, typically 60-80% of the purchase price, to fund the acquisition. The acquired company’s assets often serve as collateral for the borrowed funds, and its future cash flows are expected to service the debt, with interest payments potentially offering a tax shield under current tax codes. The firm then works to improve the company’s operations and financial performance before selling it for a higher value.
Growth equity is another strategy where private equity firms invest in relatively mature, fast-growing companies that require capital to expand operations, enter new markets, or make acquisitions. Unlike LBOs, growth equity investments typically involve less leverage and may include taking a minority stake, though a significant one, to provide strategic guidance and capital for scaling. Venture capital, while a distinct subset, also operates on the buy side by investing in early-stage, high-growth potential companies, providing seed funding or later-stage financing rounds (e.g., Series A, B, C) in exchange for equity. These investments are often characterized by high risk and the potential for substantial returns through successful innovation and market penetration.
Distressed investing involves acquiring companies that are experiencing financial difficulties or are in bankruptcy. The private equity firm aims to turn around the struggling business by restructuring its debt, improving its operations, or selling off non-core assets. This strategy requires deep financial and operational expertise to navigate complex situations and restore the company to profitability, demonstrating a direct acquisition and management approach focused on value creation.