In a typical deal, a private-equity firm buys a company, using some of its own money and some borrowed money. It then tries to improve the performance of the acquired company, with an eye toward cashing out by selling it or taking it public. The key to this strategy is debt: the model encourages firms to borrow as much as possible, since, just as with a mortgage, the less money you put down, the bigger your potential return on investment...
Having already piled companies high with debt in order to buy them, many private-equity funds had their companies borrow even more, and then used that money to pay themselves huge "special dividends". This allowed them to recoup their initial investment while keeping the same ownership stake. Before 2000, big special dividends were not that common. But between 2003 and 2007 private-equity funds took more than seventy billion dollars out of their companies. These dividends created no economic value — they just redistributed money from the company to the private-equity investors. As a result, private-equity firms are increasingly able to profit even if the companies they run go under—an outcome made much likelier by all the extra borrowing.
In this context, a recent study commissioned by the Financial Times has found that "private equity has proved better at enriching its own managers than producing investment profits for US pension funds over the past decade". Private equity firms follow the "two-twenty" annual fee rule - 2% of the committed capital as management fees and 20% of the share of profits as performance fees. The former covers not just the invested capital for that year, but the entire commitment for a long duration made by the investor. For instance, if a $1bn fund invests $100m in its first year, the $20m management fee would be 2% of committed capital, but 20% of invested capital for that year. This rule change was made by the industry body in 2001 following the massive spurt in demand for investments in private equity firms.
From 1991 to 2000, US pension funds paid an average 2% of invested capital each year in management fees, and received 21% returns, after fees, annually from their private equity investments, according to data from the CEM Benchmarking database. In contrast, after the rule change, in the 2001-10 period, US pension plans on average made only 4.5% annually, after fees, from their investments in private equity, whereas the pension funds paid an average 4% of invested capital each year in management fees on top of the performance fees. The change in returns for investors could not have been more dramatic, especially considering that 2001-07 formed the peak of the financial market bubble.
Paul Krugman points to an old paper by Larry Summers and Andrei Shleifer who had argued that leveraged buyouts are often aimed at "value redistribution" rather than "value creation". Translated into English, this would mean "asset stripping"!
Update 1 (28/1/2012)
Superb description of how a private equity firm works by James Kwak.
A private equity firm is an asset management company. It creates investment funds that raise most of their money from outside investors (pension funds, insurance companies, rich people, etc.), and then manages those funds. As opposed to a mutual fund, however, instead of buying individual stocks, these funds usually make large investments either in private companies or in public companies that they "take private". While mutual funds and most hedge funds try to make money by guessing where securities prices will go in the future, private equity funds try to make money by taking control of companies and actively managing them.