Private Equity Funds (Definition)
Private equity funds invest in private companies, with the aim of later selling their stakes at a profit, typically after five to seven years. The term “private equity” encompasses a wide variety of fund strategies with various objectives. Some funds invest seed capital in promising start-ups, while others try to turn around the fortunes of struggling industrial giants.
Private equity funds allow individuals to participate in the success of companies by investing beyond the public markets.
PE Fund General Operation Cycle
- Different from investing in a mutual fund or exchange-traded fund.
- PE funds are typically closed-end funds that operate for a limited term, typically lasting ten years.
1. “Investment Period”- Fund starts by raising money from investors and generally spend 1-10 years investing in a portfolio of companies.
- “Harvesting Period”- Next Chapter when PE funds reap the rewards of their investments.
(a) Ultimately, in this period, Fund sells its stakes in Companies and liquidates fund, but they can happen gradually, one portfolio company at a time.
- Investors receive cash proceeds as events occur (and possible special dividends at other times)
How are Individual Investments in PE Funds Initiated?
- Also very different than open-ended funds like mutual funds.
- Instead of paying money directly into the fund, investors make a commitment of a certain amount of capital, and the fund gradually draws on that money by issuing “capital calls” each time it finds a suitable company to invest in.
- If the fund can’t find enough good opportunities, the investor may end up investing less money than you had committed.
- Also, it’s generally not possible for an investor to redeem your money until the end of the fund’s specified term.
- Although it is possible for an investor to sell his or her stake on the secondary market, it’s more complicated than selling publicly-listed securities, and he or she may have to sell at a discount.
Leveraged Buyout
(LBO) Type of PE Fund. Combines investor funds with borrowed money to acquire companies and improve their profitability.
- The financial leverage can allow the company to acquire larger companies than it would otherwise be able to afford, meaning larger returns if the investments pay off.
- The private equity fund usually takes a majority stake in the company or buys it outright, allowing it to control the firm’s strategy and direction.
Venture Capital
Type of PE Fund.
-Venture capital funds invest in start-ups and early-stage companies with high growth prospects.
- Unlike leveraged buyout funds, VC funds typically take only a minority stake, leaving control in the hands of the company management. It’s a riskier strategy because the companies often have little or no track record, but it can deliver spectacular rewards.
- Sequoia Capital’s $60 million investment in WhatsApp, for example, became worth about $3 billion when the company was acquired by Facebook in 2014.
Growth Capital
Type of PE Fund.
-Growth capital is similar to venture capital but targets more mature companies.
-As with VC, this fund provides a company with the cash to fuel growth, and takes a minority stake in return. It’s less speculative than venture capital, because the firms have a longer history and are often already profitable, but the successes are not quite as dramatic as a WhatsApp.
Real Estate
Type of PE Fund.
-These funds invest in property and take a number of different strategies.
-Some funds are relatively conservative, investing in lower-risk rental properties with stable, predictable cash flows. Others invest in land or more speculative development deals, offering greater potential for returns but also greater risk.
Infrastructure
Type of PE Fund.
-Infrastructure funds invest in utilities and transportation hubs like toll roads, airports, bridges, electricity and gas networks, and hospitals.
-A popular area recently has been renewable energy, with funds investing in everything from solar power plants to offshore wind farms.
Fund of Funds
Type of PE Fund.
-In this model, the fund doesn’t invest directly in companies or assets, but instead buys into a portfolio of other private equity funds. This allows investors to achieve the benefits of greater diversification and access funds they might not otherwise have been able to invest in. These funds of funds are managed by professional investors who charge a fee for their manager selection.
Mezzanine Capital
Type of PE Fund
-Just as the mezzanine floor in a building is halfway between one floor and another, so mezzanine capital is halfway between debt and equity.
- It can take the form of subordinated notes – debt that is less secure than other loans, and so receives higher interest rates. Or the investment can be preferred stock – a form of equity that has a higher claim on company assets than common stock.
- Mezzanine funds specialize in these hybrid forms of financing, aiming to achieve higher returns than debt and lower risk than equity.
Distressed PE
Type of PE Fund
-Sometimes also called “special situations,” distressed PE funds specialize in lending to or investing in companies in serious financial difficulty.
- Because of the “distressed” state of the companies, the funds can buy shares very cheaply, and the aim is for the company to be restructured and return to financial health, yielding a profit for the fund.
- There are also hedge funds that are distressed investors, so the lines can blur between hedge funds and private equity when it comes to this style of investing.
Secondaries
Type of PE Fund
-it is possible to sell your investment commitment in a fund. Dedicated “secondaries” funds exist to buy those commitments and turn a profit on them.
-These funds also sometimes buy companies or assets from the portfolio of another private-equity fund.
Limited Partners (PE)
- Usually institutional or high net worth investors interested in receiving the income and capital gains associated with investing in the private equity fund.
- Do not take part in the fund’s active management.
- They are protected from losses beyond their original investment as well as any legal actions taken against the fund.
General Partners (PE)
- Responsible for managing the investments within the private equity fund.
- For their services, they earn a management fee (typically 2% of commitments paid annually) and a percentage of the fund’s profits, called carried interest (can range from 5-30% of profits).
- Can be legally liable for the actions of the fund.
Preferred Return Provision (PE)
(aka “hurdle rate”) Clause in a PE Compensation Agreements
Basically a minimum annual return that the limited partners are entitled to before the general partners may begin receiving carried interest. If there is a hurdle, the rate is typically around 8%.
Clawback Provision (PE)
Gives the limited partners the right to reclaim a portion of the general partner’s carried interest in the event that losses from later investments cause the general partner to withhold too much carried interest.
