private equity funds

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Private equity funds

Private equity funds are investment funds that purchase ownership positions in privately held companies. Such privately held companies are also called portfolio companies. Private equity funds will sometimes purchase companies in the public markets with the intent of taking them private.

General partners and limited partners
Private equity funds are typically structured as limited partnerships. A limited partnership has one general partner and multiple limited partners. The general partner is the active partner and is usually responsible for making all the investment and administrative decisions for the fund. The limited partners are passive investors who supply capital for the fund. The capital is typically called the equity of the fund. Limited partners are wealthy individuals, pension funds, endowments, and insurance companies.

Private equity acquisition strategies
Portfolio companies are purchased in one of four ways:

1) From another private equity fund (secondary purchase).

2) From another operating company or competitor (trade purchase, strategic purchase).

3) Purchased from the founding entrepreneur (founder purchase) or from a family that owns the company (family purchase).

4) From the public equity markets (buy out).

A private equity fund will take a position in which it owns part, a majority, or all of a company. The ownership interest can be financed with all equity or a mixture of equity and debt.

Private equity financing – the "leveraged buyout"
We will assume that the private equity fund is searching for later-stage companies. A typical private equity deal is as follows: The general partner locates an attractive company for investment. The general partner combines the equity of the fund with borrowed money – debt – and purchases the company. The ratio of debt to equity can be quite high: sometimes 90 percent.

Historically, the portion of the financing package that is debt was raised from commercial banks. In the 1980s financiers such as Michael Milken began to raise debt in the capital markets. This debt was called high-yield bonds. High-yield bonds were sometimes given the notorious name “junk bonds.” A private equity deal that is structured using high-yield bonds and a corresponding high debt-to-equity ratio is called a leveraged buyout.

Private equity fund strategies
Once the private equity fund purchases the portfolio company using whatever financing mix is appropriate, several strategies can be applied:

Asset stripping strategy
The private equity fund sells assets that the portfolio company owns. In this case the purchaser believes the sum of the parts is greater than the whole. Gordon Gekko made this strategy famous in the Hollywood movie “Wall Street.”

Passive investment strategy
The private equity fund passively holds the portfolio company and collects any dividends if any. The general partner might also sit on the board of directors and offer advice to the portfolio company. This strategy is used by Warren Buffet in private purchases to his Berkshire Hathaway fund.

Restructuring strategy
The private equity fund purchases a company and makes changes to the portfolio company that improves profitability. This strategy is probably the most popular strategy for private equity funds. American fund manager Carl Icahn is probably the most famous investor using the restructuring strategy. Another younger fund manager who restructures companies successfully is Tom Gores.

Private equity fund sell strategies
If the private equity fund decides to sell the company in its entirety, the sale can take place in one of three ways:

1) Shares of the company can be offered for sale on a public stock exchange. This is known as taking the company public.

2) The company can be sold to another private equity fund (secondary sale).

3) The company can be sold to another operating company; for example, a competitor (strategic sale).

Requirements for limited partners
Limited partners in private equity funds must be prepared to make very high minimum investments (over 1,000,000 Euros) to invest as a limited partner.

Because it usually takes several years for the general partner to execute a particular strategy, private equity fund investments require time commitments of several years (lock-up period).

Private equity fund fees
There are two types of fees in a typical private equity fund:

1) Management fees – an annual fee to pay for the private equity firm's investment operations (typically 1 to 2% of the committed capital of the fund).

2) Carried interest - a share of the profits in the amount of 20 to 30% paid to the general partner as a performance incentive. The remaining profits are paid to the limited partners.

Note: Sometimes private equity funds calculate a hurdle rate before they pay themselves. A hurdle rate is a minimum rate of return (8 to 12%) which must be achieved before the fund manager receives any carried interest payments.

Private equity fund returns
Private equity fund returns are sometimes on the order of 30 percent annually. Such returns would place private equity funds among the top performing investments.

Private equity as part of an investment portfolio
Private equity funds have a low correlation to publicly traded funds. Hence, if correlation is an issue, having exposure to the private equity asset class can create a better risk-return profile for an investment portfolio.

Conclusion
Private equity funds are a great way to add business ownership to a wealth portfolio. Because required minimum investments are high and lock-up periods are long, private equity funds are usually available to the most wealthy investors.