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Private Equity Funds |
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Private equity funds are investment funds that buy ownership positions in privately held companies (portfolio companies).
Private Equity Fund Structure The typical private equity fund is structured as a limited partnership with many limited partners. The limited partnership has a general partner. The general partner is usually responsible for making all the decisions for the investment fund. Private Equity Fund Financing The general partner will raise cash from wealthy individuals, pension funds, endowments, insurance companies. These wealthy investors make up the limited partners of the fund. The money raised from the limited partners is know as the equity of the fund. If the private equity fund is investing in later stage companies that have the capacity to service debt, the private equity fund purchases portfolio companies with a combination of debt and equity. Traditionally the debt was raised from commercial banks. And in the 1980s the debt was also raised in the capital markets. Some portfolio company purchases are highly leveraged using 10 percent equity and 90 percent debt or more. These types of purchases would be called leveraged buy outs. Private Equity Fund Strategies The generic strategy of a private equity fund is to buy a company (acquisition) and improve the company's operations (restructuring), and then sell the company (sale). Sometimes a private equity fund buys a company with the intent to sell off the company in pieces or liquidate the company. Private Equity Acquisition Strategies Portfolio companies are purchased in four main ways. 1) Acquired from another private equity fund (secondary purchase). 2) Purchased from another operating company or competitor (trade purchase, strategic purchase). 3) Purchased from the founding entrepeneur (founder purchase, family purchase) or from a family that owns the company. 4) Purchased from the public equity markets (buy out). A private equity fund will take a position in which it owns part or all or a company. Once the operations of the company are improved, the company is sold, usually for a much higher price than the price paid. Private Equity Fund Exit (Sell) Strategies The ultimate goal of the most private equity funds is to buy a company and then to sell it after its operations are improved. Portfolio company sales can take place in five main ways: 1) The company is taken public and floated on a public stock market and shares of the company are sold to the public (initial public offering). 2) The company is sold to another private equity company (secondary sale). 3) The company is sold to another operating company for example a competitor through a merger or acquisition (strategic sale). 4) The company is broken up and sold in pieces (break-up). 5) The private equity fund takes cash out of the company and pays its passive investors a preferred dividend to compensate them for the equity they contributed. Requirements for Passive Private Equity Investors Passive investors in private equity funds must be prepared to make very large investments (over 1,000,000 Euros) to invest as a limited partner. Because it usually takes several years for the general partner to make improvments to portfolio companies, private equity funds make investments which last several years or more. So passive private equity investors should be prepared for a longer lock-up period than in other types of funds. The investment investment in a private equity fund as a limited partner is a passive investment. The general partner makes all the decisions. The limited partner merely contributes capital. Private Equity Fund Fees There are two types of fees in the typical private equity fund: 1) 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). 2) 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. Sometimes private equity funds have a hurdle rate. A 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 Returns of Private Equity Funds Private Equity Funds have some of the highest returns of any type of investment fund. Returns can sometimes reach 30 percent annually. The private equity fund business has created many multi-millionaires and billionaires. Private Equity as Part of an Investment Portfolio Private equity funds have a low correlation to publicly traded funds. Hence having exposure to the private equity asset class can create a better risk return profile for an investment portfolio. |
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