Buying Companies to Sell Versus Buying to Keep

Private equity buyouts are growing for large equity purchases throughout the country. For private equity buyouts over $1 billion the total cost grew from $28 billion in 2000 to $502 billion in 2006 according to the firm Dealogic (Barber, Felix; Goold, Michael, 2007). So far in the first half of 2007 that number was already $501 billion showing nearly a doubling of the value in the first year.

Private equity firms have gained a reputation for increasing the value of their investments. This extra money has helped the overall value of the investments increase into the hundreds of billions and possibly early trillions of dollars. Part of the reason why these values are increasing is because the compensation for equity managers, the utilization of debt, focus on cash flow and overall profit margin improvement is creating more lucrative opportunities. These opportunities are drawing larger investments.

The private equity firms purchases these businesses with the desire to fix them up, strip them down and make them profitable within a short period of time. They then sell these companies to make a short-term or medium-term profit within 2 to 6 years. It doesn't make sense to hold on to them with long-term hopes of drawing continual profits from the operations.

One of the problems with hanging onto a company for the long-term is the nature of a private equity firm versus that of the company they purchased. The goal of the private equity firm is to make money for its investors. Therefore, they make short-term changes that will make the company look very profitable. The higher the profit the more they get paid. They like to make their money and get out.

The purchased company would rather be focused on long-term growth and continual profit from operations. That will require private equity firms to invest substantial money that will not be paid back for 10 or 20 years. That is way too much money and time for investors who are seeking to see short-term gains in their portfolio.

A private equity firm can earn a 25% profit for the first three years that it owns the business and resells it. If the equity firm decides to hang onto the business for some time the results of the return will be more like 12% a year but with a lot more energy and management. This all constitutes risk that is not justified by the lower but longer term profits. Therefore short-term investments are much more lucrative then buying to keep.