Private equity fund

A private equity 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 investors point of view funds can be traditional where all the investors invest with equal terms or asymmetric where different investors have different terms.

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.

Legal structure and terms

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 or LPA. Such funds have a general partner (GP), 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:

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.^[1]

Hurdle rate or preferred return

A minimum rate of return (e.g., 8–12%), which must be achieved before the fund manager can receive any carried interest payments.

Carried interest

A share of the profits of the fund's investments (typically up to 20%), paid to the private equity fund's management company as a performance incentive. The remaining 80% of the profits are paid to the fund's investors.^[1]

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.

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.

Private equity 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.

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.

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.

Private equity 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 (EBITDA). Private equity multiples are highly dependent on the portfolio company's industry, the size of the company, and the availability of LBO financing.

Portfolio company sales (or 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 IPO of the portfolio company or a sale of the company to a strategic acquirer through a merger or acquisition (M&A), also known as a trade sale. Increasingly, more common has been a sale of the portfolio company to another private equity firm, also known as a secondary sale. 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.

Private equity funds and private equity firms: an illustration

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

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.

Limited liquidity

Investments in limited partnership interests (which is 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, it is very difficult to achieve liquidity before the manager realizes the investments in the portfolio as an investor's capital is locked-up in long-term investments, which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.

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.

Unfunded Commitments

An investor's commitment to a private equity fund is drawn over time. 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.

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.

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.^[2]

For the above mentioned reasons, private equity fund investment is for those who can afford to have capital locked in for long periods of time and who are able to risk losing significant amounts of money. These disadvantages are offset by the potential benefits of annual returns, which range up to 30% for successful funds.

See also

• Private Equity for more information on the private equity asset class.
• History of private equity and venture capital
• List of private equity firms for a list of the largest active private equity investment firms.
• Limited partnership
• Limited liability company
• Taxation of private equity and hedge funds
• Hedge fund

References

• Private equity – a guide for pension fund trustees. Pensions Investment Research Consultants (PIRC) for the Trades Union Congress.

• Krüger Andersen, Thomas. Legal Structure of Private Equity Funds. Private Equity and Hedge Funds 2007.

• Prowse, Stephen D. The Economics of the Private Equity Market. Federal Reserve Bank of Dallas, 1998.

v t e Topics on private equity and venture capital Basic investment types Buyout Venture Mezzanine Growth Secondaries Equity co-investment History History of private equity and venture capital Early history of private equity Private equity in the 1980s Private equity in the 1990s Private equity in the 2000s Terms and concepts Buyout Financial sponsor Management buyout Divisional buyout Buy–sell agreement Leveraged recapitalization Dividend recapitalization Venture Seed money Startup company Angel investor Venture capital financing Pre-money valuation Post-money valuation Venture round Venture debt Bootstrap funding Structure Private equity firms and funds Limited partnership Limited liability company Carried interest Management fee Publicly traded private equity Business Development Company Venture capital trust Private investment in public equity (PIPE) Pledge fund Investors Corporations Institutional investors Pension funds Insurance companies Fund of funds Endowments Foundations Investment banks Merchant banks Commercial banks High-net-worth individuals Family offices Sovereign wealth funds Related financial terms Undercapitalization Initial public offering (IPO) M&A Leverage High-yield debt Capital structure Capital call EBITDA IRR Envy ratio Private equity and venture capital investors Private equity firms Venture capital firms Angel investors Portfolio companies

External links

• The Economics of Private Equity Funds (University of Pennsylvania, The Wharton School, Department of Finance)
• CalPERS Private Equity Industry Dictionary
• VC Experts Glossary (Glossary of Private Equity Terms)
• Guide on Private Equity and Venture Capital for Entrepreneurs (European Venture Capital Association, 2007)
• UK Venture Capital and Private Equity as an Asset Class (British Venture Capital Association)
• Note on Limited Partnership Agreements (Tuck School of Business at Dartmouth, 2003)