Private Equity investors borrow money to buy companies, find hidden stashes of cash in them, and then sell them at a big profit.
Hidden Cash in the Potatoes
Private equity firms do deals that are complicated and hard to figure out. But one thing’s for sure: they make lots of money for themselves, and for their own investors (who can be wealthy individuals, university endowments, or pension funds).
Take the Hidden Cash Group (HCG) for example, an imaginary private equity firm. They’re currently working on three deals (companies they bought):
Deal #1 is Bob’s Potatoes, a potato farming company that’s been around forever and sells to large customers like McDonalds. Their ‘hidden cash’ is that their farms are located on land which can be sold for big bucks to oil companies for fracking (pumping oil and gas). The company’s founders didn’t want to sell, because they loved their potatoes… but Hidden Cash Group had no problem doing this. Ka-ching.
Deal #2 is Legacy Media, a newspaper company that’s been declining for years but still has lots of loyal readers and advertisers. Their ‘hidden cash’ is that the readers will keep buying the paper out of habit, even with less local news in it. So Hidden Cash Group realized they could lay off lots of reporters and editors, improving short-term profitability. Ka-ching.
Deal #3 is Kisses Kandy, a company that makes a line of much-beloved, bestselling chocolates. The hidden cash is that Kisses has kept its prices really low for decades, while spending lots of money on the highest quality ingredients. So Hidden Cash Group can force the company to raise its prices – knowing that customers will keep paying – while changing the recipe to use less-expensive ingredients. This will increase profitability and enable Kisses to go public (sell their stock publicly). Ka-ching.
As you see, Hidden Cash Group is great at finding hidden cash, like most private equity firms. And since they borrow most of the money to buy these companies (requiring less cash up front), their investment returns are even higher when they sell the companies off.
They’ve found a way to get something for nothing, in more ways than one. That’s private equity.