What Is Equity, and How Does It Grow?
A post in my ongoing series on “Explaining Private Equity”
(cross-posted from Google+)
A week ago, I posted a tidbit of private equity (PE) news. The short story: PE has been in the spotlight thanks to Presidential candidate Mitt Romney, and in the midst of the public brouhaha, popular chain PepBoys was taken private by a PE firm. At the behest of some of my friends and family, I decided to explain private equity in depth.
Some of you might think: “come on, everyone knows what equity is!” Actually, since I’ve returned to the world of private equity, I’ve had a few friends ask me to explain the basic concept of equity. Of course, if you already know what equity means, the rest of this post will be awfully boring to you. But please, do share this with any of your friends who you think might be interested!
I like to explain equity in terms that most people can relate to: owning a house. When you buy a house, you own it. If you sell it, the money is yours. But there’s a caveat: if you borrowed money from a bank in the form of a mortgage, then you must pay back that mortgage (and its interest).
Let’s say you paid $100,000 for your house. $100,000 is the value of the house — not to be confused with equity, we’re getting there! You were able to get a mortgage from the bank in the amount of $80,000 in order to help buy your house. That $20,000 cushion ($100,000 home value minus the mortgage) is called the equity of the house. It’s the cash that you had to fund out of your pocket in order to purchase your home. It’s also called your equity contribution.
If you were to sell the house that same day, the $20,000 of equity would go right back into your pocket because you own the house. There’s the simple concept. You are the equity owner, and you own all the value of the home after you’ve satisfied your mortgage obligation.
Now, let’s pretend you don’t sell your house today. Instead, you sell it in five years. And voila! The economy has recovered, and home values in your neighborhood have gone up because people are feeling good, and are willing to pay more for houses. In addition, you’ve put in a new kitchen and you’ve re-sculpted your front garden. You are able to sell your house for a $150,000 value. In the mean time, because you’ve got a job, you’ve managed to pay down some of the mortgage via your scheduled monthly payments. Now you only owe $50,000 to the bank.
When you sell your house, because you own 100% of the equity in your home, the equity value that you receive is $100,000 ($150,000 minus the remaining mortgage). Your equity value has QUINTUPLED from $20,000 to $100,000. Why? The economy raised the value of the house. Your improvements (kitchen, garden) raised the value of your house. And, you were able to pay down some of the mortgage. Your equity has grown. It has appreciated.
This exact analogy works for businesses. Let’s say you absolutely love your neighborhood bakery, and you want to buy it. You think it’s worth $100,000, and the old owner agrees: He says he’ll sell the bakery to you. You ask the local bank to help you pay for the purchase, and they give you $50,000 to do so. You pay $50,000 out of your own pocket — that’s your equity contribution. The deal is done, and now you are the 100% equity owner of the neighborhood bakery. You also happen to be an amazing, charismatic pastry chef, and in five years, you’ve doubled your customers. You’ve improved the storefront with new paint and frosted glass. You’ve added in seating. And because you’ve been making money hand-over-fist, you’ve used the profits of your bakery to pay the bank back all its money already. Now, because you want to retire, you sell the bakery for a $200,000 value. That means you get to go home with all $200,000, since you own 100% of the equity of the bakery, and there is no debt. You’ve quadrupled your equity contribution.
That is the simplest definition of equity. There are countless twists and turns within the concept of equity, but so long as you start by understanding this, the rest is very simple to unravel.
I hope this was helpful to at least one person out there!
Note: All opinions contained herein are my own, and not necessarily representative of my employer(s).