Private equity fund

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A private equity fund (abbreviated as PE fund) is a collective investment scheme used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity. Private equity funds are typically limited partnerships with a fixed term of 10 years (often with annual extensions). At inception, institutional investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund. From the investors' point of view, funds can be traditional (where all the investors invest with equal terms) or asymmetric (where different investors have different terms). [1] [2]

Contents

A private equity fund is raised and managed by investment professionals of a specific private-equity firm (the general partner and investment advisor). Typically, a single private-equity firm will manage a series of distinct private-equity funds and will attempt to raise a new fund every 3 to 5 years as the previous fund is fully invested. [1]

Diagram of the structure of a generic private-equity fund Private Equity Fund Diagram.png
Diagram of the structure of a generic private-equity fund

Most private-equity funds are structured as limited partnerships and are governed by the terms set forth in the limited partnership agreement (LPA). [3] Such funds have a general partner, which raises capital from cash-rich institutional investors, such as pension plans, universities, insurance companies, foundations, endowments, and high-net-worth individuals, which invest as limited partners (LPs) in the fund. Among the terms set forth in the limited partnership agreement are the following: [4] [5]

Term of the partnership
The partnership is usually a fixed-life investment vehicle that is typically 10 years plus some number of extensions.
Management fees
An annual payment made by the investors in the fund to the fund's manager to pay for the private-equity firm's investment operations (typically 1 to 2% of the committed capital of the fund). [6]
Distribution waterfall
The process by which the returned capital will be distributed to the investor, and allocated between limited and general partner. This waterfall includes the preferred return  : a minimum rate of return (e.g. 8%) which must be achieved before the general partner can receive any carried interest, and the carried interest, the share of the profits paid the general partner above the preferred return (e.g. 20%). [6]
Transfer of an interest in the fund
Private equity funds are not intended to be transferred or traded; however, they can be transferred to another investor. Typically, such a transfer must receive the consent of and is at the discretion of the fund's manager. [7]
Restrictions on the general partner
The fund's manager has significant discretion to make investments and control the affairs of the fund. However, the LPA does have certain restrictions and controls and is often limited in the type, size, or geographic focus of investments permitted, and how long the manager is permitted to make new investments. [8]

The following is an illustration of the difference between a private-equity fund and a private-equity firm:

Private equity firmPrivate equity fundPrivate equity portfolio investments (partial list)
Kohlberg Kravis Roberts & Co. (KKR)KKR 2006 Fund, L.P.
($17.6 billion of commitments)
Alliance Boots
Dollar General
Energy Future Holdings Corporation
First Data Corp
Hospital Corporation of America
Nielsen Company
NXP Semiconductors

Investments and financing

A private-equity fund typically makes investments in companies (known as portfolio companies). These portfolio company investments are funded with the capital raised from LPs, and may be partially or substantially financed by debt. Some private equity investment transactions can be highly leveraged with debt financing—hence the acronym LBO for "leveraged buy-out". The cash flow from the portfolio company usually provides the source for the repayment of such debt. While billion dollar private equity investments make the headlines, private-equity funds also play a large role in middle market businesses. [9]

Such LBO financing most often comes from commercial banks, although other financial institutions, such as hedge funds and mezzanine funds, may also provide financing. Since mid-2007, debt financing has become much more difficult to obtain for private-equity funds than in previous years. [10] [11]

LBO funds commonly acquire most of the equity interests or assets of the portfolio company through a newly created special purpose acquisition subsidiary controlled by the fund, and sometimes as a consortium of several like-minded funds. [12] [13]

Multiples and prices

The acquisition price of a portfolio company is usually based on a multiple of the company's historical income, most often based on the measure of earnings before interest, taxes, depreciation, and amortization. Private equity multiples are highly dependent on the portfolio company's industry, the size of the company, and the availability of LBO financing. [14]

Portfolio company sales (exits)

A private-equity fund's ultimate goal is to sell or exit its investments in portfolio companies for a return, known as internal rate of return (IRR) in excess of the price paid. These exit scenarios historically have been an initial public offering of the portfolio company or a sale of the company to a strategic acquirer through a merger or acquisition, also known as a trade sale. [15] A sale of the portfolio company to another private-equity firm, also known as a secondary, has become a common feature of developed private equity markets. [14]

In prior years, another exit strategy has been a preferred dividend by the portfolio company to the private-equity fund to repay the capital investment, sometimes financed with additional debt. [16] [17]

Investment features and considerations

Considerations for investing in private-equity funds relative to other forms of investment include:

Substantial entry requirements
With most private-equity funds requiring significant initial commitment (usually upwards of $1,000,000), which can be drawn at the manager's discretion over the first few years of the fund. [18]
Limited liquidity
Investments in limited partnership interests (the dominant legal form of private equity investments) are referred to as illiquid investments, which should earn a premium over traditional securities, such as stocks and bonds. Once invested, liquidity of invested funds may be very difficult to achieve before the manager realizes the investments in the portfolio because an investor's capital may be locked-up in long-term investments for as long as twelve years. Distributions may be made only as investments are converted to cash with limited partners typically having no right to demand that sales be made. [19]
Investment control
Nearly all investors in private equity are passive and rely on the manager to make investments and generate liquidity from those investments. Typically, governance rights for limited partners in private-equity funds are minimal. However, in some cases, limited partners with substantial investment enjoy special rights and terms of investment. [20]
Unfunded commitments
An investor's commitment to a private-equity fund is satisfied over time as the general partner makes capital calls on the investor. If a private-equity firm cannot find suitable investment opportunities, it will not draw on an investor's commitment, and an investor may potentially invest less than expected or committed. [4] [10]
Investment risks
Given the risks associated with private equity investments, an investor can lose all of its investment. The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development or in companies with high amounts of financial leverage. By their nature, investments in privately held companies tend to be riskier than investments in publicly traded companies. [21]
High returns
Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets. [22]

For the above-mentioned reasons, private-equity fund investment is for investors who can afford to have capital locked up for long periods and who can risk losing significant amounts of money. These disadvantages are offset by the potential benefits of annual returns, which may range up to 30% per annum for successful funds. [23]

See also

Related Research Articles

A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments. In the United States, financial regulations require that hedge funds be marketed only to institutional investors and high-net-worth individuals.

<span class="mw-page-title-main">Leveraged buyout</span> Acquired control over a company by the purchase of its shares with borrowed money

A leveraged buyout (LBO) is one company's acquisition of another company using a significant amount of borrowed money (leverage) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. The use of debt, which normally has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition.

In the field of finance, private equity (PE) is stock in a private company that does not offer stock to the general public. Private equity is offered instead to specialized investment funds and limited partnerships that take an active role in the management and structuring of the companies. In casual usage, "private equity" can refer to these investment firms rather than the companies that they invest in.

<span class="mw-page-title-main">Venture capital</span> Form of private-equity financing

Venture capital is a form of private equity financing that is provided by venture capital firms or funds to startups, early-stage, and emerging companies that have been deemed to have high growth potential or which have demonstrated high growth. Venture capital firms or funds invest in these early-stage companies in exchange for equity, or an ownership stake. Venture capitalists take on the risk of financing risky start-ups in the hopes that some of the companies they support will become successful. Because startups face high uncertainty, VC investments have high rates of failure. The start-ups are usually based on an innovative technology or business model and they are usually from high technology industries, such as information technology (IT), clean technology or biotechnology.

<span class="mw-page-title-main">Resolution Trust Corporation</span> American government-owned asset management company

The Resolution Trust Corporation (RTC) was a U.S. government-owned asset management company run by Lewis William Seidman and charged with liquidating assets, primarily real estate-related assets such as mortgage loans, that had been assets of savings and loan associations (S&Ls) declared insolvent by the Office of Thrift Supervision (OTS) as a consequence of the savings and loan crisis of the 1980s. It also took over the insurance functions of the former Federal Home Loan Bank Board (FHLBB).

<span class="mw-page-title-main">Equity co-investment</span>

An equity co-investment is a minority investment, made directly into an operating company, alongside a financial sponsor or other private equity investor, in a leveraged buyout, recapitalization or growth capital transaction. In certain circumstances, venture capital firms may also seek co-investors.

In finance, the private-equity secondary market refers to the buying and selling of pre-existing investor commitments to private-equity and other alternative investment funds. Given the absence of established trading markets for these interests, the transfer of interests in private-equity funds as well as hedge funds can be more complex and labor-intensive.

<span class="mw-page-title-main">Campbell Lutyens</span> American independent private equity advisory firm

Campbell Lutyens is an independent private markets advisory firm exclusively focused on primary fundraising, secondary transactions and GP capital advisory services in the private equity, private debt, infrastructure and sustainable investing markets. The firm has offices in London, New York City, Paris, Chicago, Los Angeles, Charlotte, Hong Kong and Singapore and comprises a team of over 200 professionals representing over 40 nationalities.

<span class="mw-page-title-main">Taxation of private equity and hedge funds</span>

Private equity funds and hedge funds are private investment vehicles used to pool investment capital, usually for a small group of large institutional or wealthy individual investors. They are subject to favorable regulatory treatment in most jurisdictions from which they are managed, which allows them to engage in financial activities that are off-limits for more regulated companies. Both types of fund also take advantage of generally applicable rules in their jurisdictions to minimize the tax burden on their investors, as well as on the fund managers. As media coverage increases regarding the growing influence of hedge funds and private equity, these tax rules are increasingly under scrutiny by legislative bodies. Private equity and hedge funds choose their structure depending on the individual circumstances of the investors the fund is designed to attract.

<span class="mw-page-title-main">Alternative investment</span> Investments other than stocks, bonds and cash

An alternative investment, also known as an alternative asset or alternative investment fund (AIF), is an investment in any asset class excluding capital stocks, bonds, and cash. The term is a relatively loose one and includes tangible assets such as precious metals, collectibles and some financial assets such as real estate, commodities, private equity, distressed securities, hedge funds, exchange funds, carbon credits, venture capital, film production, financial derivatives, cryptocurrencies, non-fungible tokens, and Tax Receivable Agreements. Investments in real estate, forestry and shipping are also often termed "alternative" despite the ancient use of such real assets to enhance and preserve wealth. Alternative investments are to be contrasted with traditional investments.

A private equity firm is an investment management company that provides financial backing and makes investments in the private equity of startup or operating companies through a variety of loosely affiliated investment strategies including leveraged buyout, venture capital, and growth capital. Often described as a financial sponsor, each firm will raise funds that will be invested in accordance with one or more specific investment strategies.

Private equity real estate is a term used in investment finance to refer to a specific subset of the real estate investment asset class. Private equity real estate refers to one of the four quadrants of the real estate capital markets, which include private equity, private debt, public equity and public debt.

<span class="mw-page-title-main">History of private equity and venture capital</span> Aspect of history

The history of private equity, venture capital, and the development of these asset classes has occurred through a series of boom-and-bust cycles since the middle of the 20th century. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital experienced growth along parallel, although interrelated tracks.

<span class="mw-page-title-main">H.I.G. Capital</span> US private equity and alternative assets investment firm

H.I.G. Capital is a private equity and alternative assets investment firm with $59 billion of equity capital under management. Based in Miami, Florida, the firm operates a group of private equity, growth equity, credit/special situation, primary lending, syndicated credit, and real estate funds. The company provides debt and equity capital to small and mid-sized companies.

<span class="mw-page-title-main">Early history of private equity</span> Aspect of history

The early history of private equity relates to one of the major periods in the history of private equity and venture capital. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital experienced growth along parallel although interrelated tracks.

<span class="mw-page-title-main">Private equity in the 1990s</span> Aspect of history

Private equity in the 1990s relates to one of the major periods in the history of private equity and venture capital. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital, experienced growth along parallel although interrelated tracks.

<span class="mw-page-title-main">Private equity in the 2000s</span> Aspect of history

Private equity in the 2000s represents one of the major growth periods in the history of private equity and venture capital. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital expanded along parallel and interrelated tracks.

Publicly traded private equity refers to an investment firm or investment vehicle, which makes investments conforming to one of the various private equity strategies, and is listed on a public stock exchange.

Entrepreneurial finance is the study of value and resource allocation, applied to new ventures. It addresses key questions which challenge all entrepreneurs: how much money can and should be raised; when should it be raised and from whom; what is a reasonable valuation of the startup; and how should funding contracts and exit decisions be structured.

<span class="mw-page-title-main">Eaton Partners</span>

Eaton Partners is a global placement agent that assists in raising capital for funds managed by some of the largest private equity firms, hedge funds, real assets and real estate funds in the world. The firm is also one of the oldest placement agents in the private funds industry. Eaton Partners raises capital primarily from institutional investors including private and public pension funds, endowment funds, family offices, fund of funds, foundations and other large pools of money that invest in alternative asset classes.

References

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Further reading