This article is about private equity investment funds. For private equity fund managers or financial sponsors and an overview of the industry, seeprivate equity firmandprivate equity.
The references used may be made clearer with a different or consistent style ofcitationandfootnoting.
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Aprivate equity fundis acollective investment schemeused for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated withprivate equity. Private equity funds are typicallylimited partnershipswith a fixed term of 10 years (often with annual extensions). At inception,institutional investorsmake an unfunded commitment to the limited partnership, which is then drawn over the term of the fund. From the investors point of view, funds can be traditional (where all the investors invest with equal terms) orasymmetric(where different investors have different terms).12
A private equity fund is raised and managed by investment professionals of a specificprivate equity firm(thegeneral partnerand investment advisor). Typically, a singleprivate equity firmwill 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.1
Most private equity funds are structured aslimited partnershipsand are governed by the terms set forth in the limited partnership agreement or LPA.3Such 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:45
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 funds manager to pay for the private equity firms investment operations (typically 1 to 2% of the committed capital of the fund.
Distribution Waterfall: The process by which the returned capital will be distributed to the investor, and allocated between Limited and General Partner. This waterfall includes thepreferred return: a minimum rate of return (e.g. 8%) which must be achieved before the General Partner can receive any carried interest, and theCarried interest, the share of the profits paid the General Partner above the preferred return (e.g. 20%).
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 funds manager.
Restrictions on the General Partner: The funds 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.
The following is an illustration of the difference between a private equity fund and aprivate equity firm:
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 withdebt financinghence the acronym LBO for leveraged buy-out. The cash flow from the portfolio company usually provides the source for the repayment of such debt. While billion dollar private equity investments make the headlines, private equity funds also play a large role in middle market businesses.9
Such LBO financing most often comes from commercial banks, although other financial institutions, such as hedge funds andmezzanine 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.1011
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.1213
The acquisition price of a portfolio company is usually based on a multiple of the companys 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 companys industry, the size of the company, and the availability of LBO financing.14
A private equity funds ultimate goal is to sell orexitits 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 anIPOof 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.15A sale of the portfolio company to another private equity firm, also known as asecondary, has become common feature of developed private equity markets.14
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.1617
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 managers discretion over the first few years of the fund.
Limited liquidity: Investments in limited partnership interests (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, liquidity of invested funds may be very difficult to achieve before the manager realizes the investments in the portfolio because an investors capital may be locked-up in long-term investments for as long as twelve years. Distributions may be made only as investments are converted to cash with limited partners typically having 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 forlimited partnersin private equity funds are minimal. However, in some cases, Limited Partners with substantial investment enjoy special rights and terms of investment.
Unfunded Commitments: An investors commitment to a private equity fund is satisfied over time as the general partner makes capital calls on the investor. If a private equity firm cannot find suitable investment opportunities, it will not draw on an investors 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 inventure capitalfunds, which invest in companies during the earliest phases of their development or in companies with high amounts of financialleverage. By their nature, investments inprivately heldcompanies tend to be riskier than investments inpublicly tradedcompanies.
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.
For the above-mentioned reasons, private equity fund investment is for investors who can afford to have capital locked up for long periods and who can risk losing significant amounts of money. These disadvantages are offset by the potential benefits of annual returns, which may range up to 30% per annum for successful funds.23
History of private equity and venture capital
List of private equity firmsfor a list of the largest active private equity investment firms.
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Kaplan, Steven N., and Antoinette Schoar. Private equity performance: Returns, persistence, and capital flows. The Journal of Finance 60.4 (2005): 1791-1823.
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Private Equity Fund Investments: New Insights on Alignment of Interests, Governance, Returns and Forecasting
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Research Handbook on Hedge Funds, Private Equity and Alternative Investments
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A closer look: Private equity co-investment: Best practices emerging
. PwC Financial Services Regulatory Practice, January, 2015.
Krger 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.
The Economics of Private Equity Funds(University of Pennsylvania, The Wharton School, Department of Finance)
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)
Private equity a guide for pension fund trustees. Pensions Investment Research Consultants (PIRC) for the Trades Union Congress.
History of private equity and venture capital
(Venture capital fundMezzanine investment fundsVulture fund)
Wikipedia references cleanup from October 2015
Articles covered by WikiProject Wikify from October 2015
This page was last edited on 3 June 2019, at 20:47