DEFINITIONS USED IN PRIVATE EQUITY; GLOSSARY OF TERMS IN PRIVATE EQUITY.
The following is the glossary of terms commonly used in private equity, growth equity and venture capital.
- Accredited Investor – An individual Accredited Investor must have a minimum net worth of $1 million or a gross income in excess of $200,000 (or joint income with the investor’s spouse in excess of $300,000) in each of the two previous years and must reasonably expect to maintain that level of income for the current year. An entity Accredited Investor generally must have total assets of $5 million or more.
- Angel Investor – A wealthy individual, commonly an entrepreneur, who provides backing to businesses or business concepts in their very early stages.
- Board Seats – Private equity firms often acquire board of director positions of the companies in their portfolios, thus giving these firms a means of monitoring and managing the companies in which they have invested.
- Bridge Financing – Temporary funding that “bridges” the time between receipt of the bridge financing and when it is eventually replaced with permanent capital.
- Buyout – see “Leveraged Buyout”
- Burn rate– The rate at which a company requires additional cash to keep going.
- Capital Account Statement – A statement of each limited partner’s pro-rata share of the partnership’s profit, loss, income and assets.
- Capital Call – When a private equity fund manager (usually a general partner in a partnership) requests that an investor in the fund (a limited partner) provide additional capital. Usually, a limited partner will agree to a maximum investment amount, and the general partner will make a series of capital calls over time to the limited partner as investment opportunities arise. Most general partners call down capital only as they require it, rather than drawing it down in preset amounts according to a rigid timetable. Capital may also be called to cover fund expenses.
- Carried Interest – Carried interest, also referred to as “carry” or “promote,” is the share of the partnership profits received by the general partner, with 20% carried interest as the industry standard (although it can be higher or lower in certain cases and varies whether a fund of funds or single-manager fund). The remaining 80% is retained by the limited partners.
- Cash Multiple – Also known as Return Multiple (see “Distributions to Paid-In Capital”)
- Catch-Up Period – Once the general partner provides the limited partners in a fund with their preferred return if any, the catch-up period begins, during which the general partner receives the majority or all of the profits until the agreed-upon profit split (as determined by the carried interest) is reached.
- Clawback – The clawback provision is a common term found in a private equity partnership agreement that requires
the partnership to undergo a final accounting of all of its capital distributions when the fund is concluded. This task is designed to ensure that the general partner receives no more than its contractual share of the profits. A clawback goes into effect when it is found that the general partner group has taken too much carry, a situation that typically arises when there are realized gains on early investments and significant losses on later investments.
- Co-Investor – Although this term is loosely interpreted to mean any two parties investing alongside each other in the same company, in the context of limited partners in a fund, it carries a highly specific meaning. A limited partner in a fund who has co-investment rights can invest directly in a company that is also backed by the fund managers. In this way, the limited partner ends up with two separate stakes in the company: the first indirectly through the private equity fund to which the limited partner has contributed; the second through its direct investment. Some private equity firms offer co-investment rights to encourage limited partners to invest in their funds.
- Commitment – A limited partner’s obligation to provide a certain amount of capital to a fund. The period in which an investor’s obligation to contribute capital to the private equity fund for investment purposes—typically, the first four to five years of the term of the fund—is called the “commitment period.”
- Compound Annual Growth Rate (“CAGR”) – The year-over-year growth rate applied to an investment or other aspect of a firm using a base amount.
- Chinese walls– Arrangements that prevent sensitive information from being passed between different parts of the same organisation, to prevent a conflict of interest or breach of confidentiality
- Deal Flow – The rate at which a fund reviews the number of potential investments in any given period.
- Distressed Debt – A private equity or hedge fund investment strategy that involves the purchase of debt securities trading at a significant discount to par value.
- Distributions – Cash or stock returned to the limited partners after the general partner has exited from an investment. A stock distribution is sometimes called an “inkind” distribution.
- Distributions to Paid-In Capital (also known as “Cash Multiple” or “Return Multiple”) – The amount a partnership has distributed to its investors relative to the total capital contribution to the fund. Return multiples, coupled with IRRs (see definition), are typical performance metrics used in evaluating private equity investment performance.
- Dividend cover– Calculated by dividing earnings after tax by the net dividend and expressed as a multiple. It shows how many times a company’s dividends are covered by post-tax earnings.
- Early Stage – A fund investment strategy involving investment in start-up companies for initial product development, marketing, manufacturing and sales activities.
- Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) – A measure of a company’s cash flow, calculated by looking at earnings before the deduction of interest expenses, taxes, depreciation and amortization. EBITDA is often used as a measure of financial performance for leveraged companies, such as those that have undergone a leveraged buyout.
- Exit – The means by which a private equity firm realizes a return on its investment. This typically comes when a portfolio company goes public, or when it merges with or is acquired by another company.
- Earn-out– Part of the price of a transaction, which is conditional on the performance of the company following the deal.
- Envy ratio– The ratio between the effective price paid by management and that paid by the private equity firm for their equity stakes in the company. The higher the envy ratio the better the deal is for management. The ratio depends on how keen the private equity firm is to do the transaction, what competition they are facing and the general economic conditions at the time of doing the deal.
- General Partner – Term used to distinguish the firm that is managing the private equity fund on behalf of the limited partners (i.e., the individuals or the institutional investors who provide capital to the fund).
- General Partner Contribution – The amount of capital that the fund manager contributes to its own fund in the same way that a limited partner does. This can be an important way in which limited partners can ensure that their interests are aligned with those of the general partner.
- Growth Stage (also known as “Middle Stage”) – A fund investment strategy involving financing for a company that
has received one or more rounds of financing and is generating revenue from its product or service.
- Internal Rate of Return (“IRR”) – The IRR is a measure of private equity performance. IRRs are determined by the amount and timing of cash inflows and outflows, as well as the residual value of investments at the end of the measurement period. Gross IRR refers to the rate of return before management fees, expenses, and carried interest. Net IRR refers to the rate of return after management fees, expenses and carried interest. There are several different methodologies for computing IRRs. Two popular methods are the “calendar time” and the “time zero” methods. The “calendar time” approach (sometimes called “dollar-weighted” in the private equity industry press) entails lining up all drawdowns and returns of capital in the year (or quarter, month or even the day) during which they occurred. The “time zero” method assumes that all investments are made at the inception of the fund. These different methods can produce dramatically different IRRs.
- IPO– Initial Public Offering, “flotation”, “float”, “going public”, “listing” are just some of the terms used when a company obtains a quotation on a stock market. Stock markets include the Official List of the London Stock Exchange, the Alternative Investment Market (AIM), NASDAQ (USA) and other overseas exchanges.
- J-Curve – The J-Curve is a term used to describe the impact of management-fee drag and potential write-downs of underperforming portfolio companies on the performance of a private equity fund early on in the fund’s lifecycle. These combined effects generally cause performance (as measured by IRRs) to dip down, taking the shape of the letter “J,” in the early years of the life of the fund when most of the portfolio is typically held at cost.
- Later Stage – A fund investment strategy involving financing for the expansion of a company that is producing, shipping and increasing its sales volume.
- LBO (Leveraged Buyout) – A fund investment strategy typically involving the acquisition of a relatively mature product or business, from either a public or private company, utilizing a significant amount of debt (typical LBO transactions today are funded with about 30%-40% equity and 60%- 70% debt).
- Lead Investor – The firm or individual that organizes a round of financing and usually contributes the largest amount
of capital to the deal.
- Leverage – The use of borrowed money to acquire assets, build operations and increase revenues. By using debt, a company attempts to achieve these results faster. But if the company underperforms, it may be at risk of not being able to make payments on the debt.
- Limited Partner(s) – Institutions or individuals contributing capital to a private equity fund. Limited partners typically are pension funds, private foundations, university endowments and high net worth individuals.
- Limited Partnership – The legal structure used by most private equity funds, usually fixed-life investment vehicles. The general partner or management firm manages the partnership using the policy laid down in a partnership agreement, which also covers terms, fees, structures and other items agreed upon between the limited partners and the general partner.
- Management Buy-Out (MBO) – The acquisition of a company by its management, often with the assistance of a private equity investor.
- Management Fee – An annual fee, typically a percentage of limited partner commitments to a fund, appropriated to cover the basic costs of running and administering a fund. Management fees tend to run in the range of 1.5% to 2.5% per year. In the later years of a partnership, these fees are often scaled down to reflect the reduced workload of the general partner. Unlike carried interest, management fees are not intended to be primary sources of incentive compensation for investment teams.
- Mezzanine Financing – Mezzanine financing can have different meanings as it relates to both VC and buyouts. With respect to VC, mezzanine financing can be defined as an investment provided to a company that is already producing and selling a product or service, for the purpose of helping the company achieve a critical objective that will enable it to go public. Within the context of buyouts, mezzanine financing is an investment strategy involving subordinated debt (the level of financing senior to equity and below senior debt).
- NASDAQ Composite – The NASDAQ Composite is an unmanaged stock index with an emphasis on technology-oriented companies. Investing in the NASDAQ Composite is subject to sector risk as well as the general risks of equity investing, which include, among others, market risk and the volatility of returns.
- PIPEs – An acronym for “private investment in public entities.” The term specifically denotes a private investment in a publicly held company.
- Portfolio Company – The term used to describe investment in a company held by a private equity manager.
- Preferred Return – The preferred return is the minimum annual IRR sometimes provided to the limited partners before the general partner shares in profits. In effect, the preferred return ensures that the general partner will share in the profits of the partnership only to the extent that the investments perform at a minimum “acceptable” level.
- Pre-Money Valuation – Typically, a VC valuation metric refers to the value of a company before an investor’s money is invested. It is usually contrasted with a post-money valuation that combines a company’s pre-money valuation with the value of the money invested. For example, a company with a pre-money valuation of $10 million that receives $5 million in investment would have a post-money valuation of$15 million, consisting of the $10 million pre-money value of the company plus the $5 million invested.
- Private Equity – Negotiated and often highly structured private investments in companies in return for an ownership interest. Private equity investments are generally illiquid and, as such, are considered long-term investments. Private equity is composed of but is not limited to, the following subcategories: leveraged buyouts, VC, mezzanine debt financing, distressed debt, real estate, development capital and special situations.
- Private Placement – This term is used specifically to denote a private investment in a company that is publicly or privately held.
- Purchase Multiple – Typically, a buyout valuation metric that refers to the multiple of cash flow (i.e., EBITDA—earnings before interest, taxes, depreciation and amortization) that a private equity firm pays in the acquisition of a company.
- Qualified Purchaser – These include individuals and family entities with minimum net investment assets of $5 million or other entities with minimum net investment assets of $25 million (e.g., corporations, public foundations and endowments).
- Ratchet – A provision that enables a VC firm to maintain its percentage ownership in a company despite the company’s future issuance of additional shares to other entities.
- Schedule K-1 Statement – The Internal Revenue Service form sent to investors by a partnership, which provides the flow-through income and expenses to be reported on an investor’s individual tax return.
- Seed-Stage Investment – Seed rounds are initial rounds invested in companies at very early stages of development, typically with the founders and product developers on board but without a complete management team in place.
- Standard & Poor’s 500 Index – The Standard & Poor’s 500 Index (“S&P 500”) is a capitalization-weighted index of 500 stocks trading in US equity markets. Performance is calculated on a total return basis.
- Strategic Buyer – This term typically describes larger corporations that purchase smaller companies or assets that relate to their core group of businesses. Strategic buyers can often extract synergies from the purchase of complementary assets. Private equity managers can sell their portfolio companies to strategic buyers as a means of realizing their investment.
- Venture Capital – Venture capital typically refers to money provided by investors to development-stage, privately held companies that are early in their life cycle with perceived high growth potential.
- Vintage – A term used to describe the year of fund formation and first takedown of capital. The concept of vintage year is used when benchmarking the performance of different private equity funds.
- Write-down – A reduction in the value of an investment.
- Write-off – The write-down of a portfolio company’s holdings to a valuation of zero, in which case the private equity investors receive no proceeds from their investment and the investment is usually removed from the fund’s portfolio.
- Private Equity term sheet (offer letter)
- Gender Smart Investing: a growing opportunity
- Areas to cover in your business plan
- The advantages of private equity over senior debt
- Stages of venture capital funding
- World’s top 10 private equity firms
- Private Equity Investment Strategies
- Top sources for startup funding
- Leveraged Buyouts
- Private Equity
- Mezzanine Financing
About the author
Dileep K Nair
Mr Dileep is currently the managing partner of Unifinn Capital Global and an advisor to the investment banking and corporate finance world. He is a mentor, entrepreneur, business advisor and investment banking expert with an overall 19 years of experience in investment banking, retail banking and corporate finance and business management. He handled a wide range of corporate finance transactions, including private equity funding, private debt, venture capital, angel investing, M&A, LBO etc worldwide.