The business pages have been covered with stories of private equity recently. The headlines come so thick and fast that it sometimes feels like the whole of the corporate world has been bought up by these mysterious private equity firms.

And even if you take a closer look, you could be forgiven for thinking that was indeed the case. A handful of private equity firms now own enough companies to be providing one-in-five jobs in the UK private sector.

The AA, Birds Eye and EMI are among the big names that have been snapped up by private equity firms recently, and Sainsbury’s is another one being stalked. And while ‘private equity’ may sound a little less sinister than ‘leveraged buy-out’, that is essentially what this is.

Private equity companies borrow money to buy other companies and later sell them on, preferably raking in a sizeable profit in the process. The funds come from a variety of sources, including wealthy individuals and pension funds. The private equity firm owns the funds as a limited company, with investors acting as limited partners. When an investment opportunity comes along, the partners stump up their percentage of the investment, and the rest of the process is managed by the private equity firm.

Often, a large amount of borrowing will make up any shortfall, and that debt is repaid by the returns on the investment – so these are highly geared, risky investments. Naturally, with a lot of borrowing involved, they rely to a large degree on a favourable rate of interest if those debts are to remain affordable. When interest rates begin to rise, the game is shakier still.

A good exit strategy is as important to private equity firms as a good purchase, and with the aim being to sell at a huge profit, deals are potentially very lucrative. The best funds can achieve returns of more than 20 per cent – and what charity would turn that down? But the stakes are high, with investment returns relying wholly on the ability of the private equity company to manage its buy out, the running of the company and subsequent sell-off, successfully. There is a chance investors could lose everything.

Unions are highly critical of private equity buyouts, which have a reputation for bringing with them job cuts and disruption in the effort to slim down a company and make it a more attractive and saleable prospect.

So with all this in mind, should charities even consider jumping aboard the private equity bandwagon? David Bailey, head of charities at Aberdeen Asset Management, argues that they should. “Dynamic asset allocation benchmark models should include private equity for a multi-asset charity mandate, unless trustees are risk averse or there are specific liquidity requirements for the portfolio,” he says.

For many organisations, of course, liquidity is a huge issue, which means the minimum investments required, and the length of time these will be tied up, puts private equity out of reach for the majority of charities.

Bailey explains: “Normally the threshold level of investment in unquoted vehicles (or Limited Liability Partnerships) is set at such a level that only charities with assets over £20 million can access the funds, and usually they have to lock away their investment for seven years, which is the traditional lifecycle of private equity.”

There are, says Bailey, no common investment funds in existence specialising in private equity investment, since liquidity and fee scales present “significant impediments” for investors.

And this is not the only thing that could put charity investors off. Trustees have a duty to be prudent with investments, and, says Nick Sladden of accountancy firm Baker Tilly: “If you have investments of less than £5 to £10 million it may be difficult to argue that you are being prudent by investing in private equity.”

But look at private equity from a different point of view and it could form part of an investment strategy that not only fits in with trustees’ investment obligations, but also helps to support an organisation’s charitable aims.

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The Wellcome Trust, the giant medical research charity, went some way to turning the private equity debate on its head when it formed a consortium with private equity firm Terra Firma and attempted to buy Boots. “Did they look at this purely as an investment, or did they plan to turn Boots into a major social enterprise?” asks Malcolm Hayday of Charity Bank.

The answer in this case is not clear, but the idea is one that could have legs. The Wellcome Trust is, of course, absolutely huge. As the largest UK charity, and the second largest medical charity in the world, what it does with its money most charities could only dream of. Indeed, for most the idea of branching out into alternative investments of any kind is simply too risky a notion. Portfolios instead stay sensibly grounded in more staid sectors.

John Tickle, head of institutional investment at Legal & General, says: “Wellcome Trust can afford to diversify in that way but most charities are relatively small and rely far more on the flow of investment income to carry out their activities.” For example, only a few charities head in the direction of the traditionally risky hedge fund, he says. Indeed over all, the average charity invests only three per cent of its funds in alternative investments, excluding property.

However, according to Tracey Reddings, executive director, financial services, at the Charities Aid Foundation, there is room for a blurring of the lines between private equity in its purest form, the type Wellcome Trust has been experimenting in, and social investment, so that charities can buy into and profit from a new form of private equity.

“You have to challenge the way people see private equity,” she says. “Traditional private equity does not fit in with the charity ethos.” However, explains Reddings: “We are beginning to see more and more private equity houses that are interested in ‘ethical’ businesses.”

And what the private equity firms are looking for is easy enough to find. “There are a lot of social enterprises setting up and these are just the sort of companies that will need private equity,” she says. “And for the investor, the returns are not just about financial gain but also social impact.”

The mindset is beginning to change and investors are moving in this direction, and there is no reason why charities should not do the same, says Reddings. “You can see why people are getting really excited about this. You can take the best of private equity and apply those principles to funding social enterprises. Charitable objectives can be aligned with investments.”

Again, the risk involved may be too great for some charities to see this as a viable investment option, but then there are tax advantages to social investment, explains Baker Tilly’s Sladden; many charities prefer to write off their social investment for tax purposes, seeing any financial return as a bonus.

But, argues Reddings, what on paper looks like a high risk venture may in fact be a very real opportunity. “Some organisations might be deemed to be high up in the risk spectrum because they are unknown, small, start-ups. The perceived risk may be higher, but the actual risk is much lower. There are good businesses that are just short of money. They will deliver if the capital is there.”

So why shouldn’t charities get involved by providing that capital in an amalgamation of private equity and social investment? To an extent, some already do. Reddings was responsible for raising £10 million from the charity sector to fund CAF Bank, “which is as close to private equity as you can get” she says. Investors are hoping for financial gain, but they are also buying into something that fits with their ethical stance.

Not all organisations are in a position to join the party, and much of the argument against still comes down to size. Charities at the top end may be able to afford to buy into burgeoning social enterprises and ethical businesses following the private equity model, but smaller organisations will find it harder to justify.

As Aberdeen’s Bailey points out, there are no common investment funds allowing access to charities wishing to buy into this area at a lower level of investment, but Reddings feels strongly that this should not remain the case.

A CIF investing in private equity funds could one day provide the answer, she says. “It may be five to 10 years away but I think it will happen. There is much more drive to support social enterprise businesses. The wave of change is only just beginning.”

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