Private equity fund

From Wikipedia, the free encyclopedia

Private equity fund is a pooled investment vehicle 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.

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.

[edit] Legal Structure and Terms

Diagram of the structure of a generic private equity fund

As discussed, 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]

• 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]

• 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

• 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

[edit] 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.

[edit] 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.

[edit] 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 or "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 (though this is currently difficult to obtain).

[edit] 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:

[edit] See also

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

[edit] 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 • d • e Topics on private equity and venture capital Basic investment types Bootstrap funding · Venture · Buyout · 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 Venture Seed money · Startup company · Angel investor · Venture capital financing · Pre-money valuation · Post-money valuation · Venture round · Venture debt Structure Private equity firms and funds · Limited partnership · Limited liability company · Carried interest · Publicly traded private equity · Private Investment in Public Equity (PIPE) Investors Institutional Investors · Pension funds · Insurance companies · Endowments · Investment Banks · Commercial Banks · Fund of funds · High net worth individuals · Family offices · Sovereign wealth funds Related financial terms Undercapitalization · Initial Public Offering (IPO) · Mergers and acquisitions · Leverage · High-yield debt · Capital structure Private equity and venture capital investors · Private equity firms · Venture capital firms · Portfolio companies

[edit] 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)