THE MECHANICS OF PRIVATE EQUITY INVESTING; HOW PE INVESTING WORK?

By Dileep K Nair Corporate Finance Private Equity June 7, 2022

HOW DOES PRIVATE EQUITY INVESTING WORK? HOW DO PRIVATE EQUITY FUNDS WORK?

WHAT IS PRIVATE EQUITY? UNDERSTANDING PRIVATE EQUITY (PE)

Private Equity (PE) is another source of investment capital that invests in the equity capital of privately held companies, I.e. companies that are not publically traded. Private Equity actually derives from high net worth individuals and institutional investors that acquire equity shares of privately held companies or acquire a controlling stake in publically traded companies to make them private, eventually becoming delisted from public stock exchanges. These companies are not listed or traded on any stock exchanges. The PE capital can be used to develop new products and technologies, expand working capital, make acquisitions, or strengthen a company’s balance sheet. Now private equity has gained a great amount of influence in today’s financial marketplace.

Private equity investors generally work towards funding new technology, making new acquisitions, expanding working capital and bolstering the balance sheets of companies. Private Equity firms also work in the same manner as Venture Capitalists — invest in the long term in startups to help them grow and then reap benefits after the companies go public or merge with other firms. Unlike mutual funds or hedge funds, however, private equity firms often focus on long-term investment opportunities in assets that take time to sell with an investment time horizon typically of 10 or more years.

(1) Private Equity lifecycle

Most private equity funds operate under a 10-year term in which the fund seeks to identify promising portfolio companies, make investments, improve the portfolio companies, sell them, and then return the proceeds to the LPs. It is likely that an investor’s return in the first few years will be negative as the GP makes investments and draws down capital while incurring fees and expenses for the fund. This phenomenon is also referred to as the “j-curve.”

The mechanics of private equity investing are illustrated in the below figure. Most private equity investors access the asset class through capital commitments to private equity limited partnerships. These limited partnerships then make direct investments in companies or funds (e.g., funds of funds).

(2) General Partner/ Limited Partner Relationship

The manager of a partnership is called the “general partner,” while the individuals and institutional investors who provide the majority of the capital are called the “limited partners.” Typically, the general partner will also contribute at least 1% of total commitments raised to the partnership, and principals of the firm may also invest additional personal capital in the fund. The general partner is responsible for reviewing investment opportunities and has authority over investment decisions. Limited partners have no discretion over investment decisions and do not take part in day-to-day management activities.

(3) Fund Raising

A private equity fund only accepts new commitments for a defined period of time. This fundraising period can be as short as a few days, or as long as 18 months or more. After a GP receives the targeted amount of committed capital from investors, the fund is deemed to be “closed.” While there are differing opinions on the exact definition of the vintage year, it is widely accepted that the year of the fund’s first close is referred to as the fund’s vintage year. Many funds offer additional closes past the first close. Once the fund has its final close, the amount of capital in the fund is fixed and no new investors can access the fund other than through a secondary transaction.

(4) Capital Calls

In a private equity partnership, capital is drawn down from the limited partners in a series of events known as “capital calls.” Private equity managers generally only call capital when they are ready to make an investment. Calling capital without making an investment acts as a “cash drag” on performance. Since fund managers are compensated for performance, they are motivated to closely match capital calls with their investment pace.

(5) Investment Period

The period of time in which the partnership is allowed to make new investments is called the “investment period.” Most funds have five- to six-year investment periods that begin once operations commence. Thereafter, the manager usually reserves the right to draw down uncalled capital only to make follow-on investments and cover expenses.

After the first close, GPs do not demand the LPs write a check for the entire commitment up front. Rather, to maximize efficient use of capital, GPs will call capital down from the LPs as the fund identifies and makes new investments. Capital is called from investors over a three to six-year investment period as opportunities are identified and investments are made. When the GP sells an investment, it will typically distribute capital back to the LPs in the same manner. The timing and amount of both the contributions and distributions affect the performance of a fund.

Limited partners are contractually obligated to honour their capital calls as dictated by the terms of the limited partnership agreement. Investors who default on their capital commitments can lose their entire interest in the partnership and are subject to potential legal action by the general partner to collect the unfunded portion of their commitments.

(6) Harvest Period — Capital Distributions

Existing portfolio company investments typically begin to be exited three to five years after the original investment, the harvest period, generating distributions that flow back to investors. For example, an early portfolio company investment made in year one could see a distribution from an exit around years four to six. While a later portfolio company investment made in year five could be exited in years 8 to 10.

(7) Management Fees and Profit Incentives

(a) Management Fees

In most private equity partnerships, a general partner receives a management fee and a percentage of the profits or “carried interest.” Typical management fees run between 1.5% and 2.5% of total capital commitments per year during the commitment period. Thereafter, the base amount on which a management fee is calculated is typically reduced by the cost of realized investments (i.e., the management fee is charged on “invested capital”). In addition to a management fee, a general partner will also earn a carried interest, which is a profit incentive for the general partner (typically 20% of gross profits, although some firms take as much as 30%).

(b) Carried Interest

The carried interest is intended to provide the manager with the bulk of its compensation and helps align its interests with those of the limited partners. Many funds also have a “preferred return” feature, which is the minimum IRR that the manager must generate for investors before sharing in profits. The preferred return ensures that the private equity manager will share in the profits of the fund only to the extent that the investments perform at a minimum “acceptable” level, commonly 7-8% for LBO funds. If a manager does not exceed the fund’s specified preferred return, it is not entitled to take its carried interest.

(c) Clawback

Most private equity partnerships have what is called a “clawback” provision, which 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 has taken too much carry, a situation that typically arises when there are realized gains on early investments and significant losses on later investments.

(d) Advisory Fees

Finally, private equity firms may charge fees to their portfolio companies. These fees often represent advisory, transaction, break-up, monitoring and/or other related fees. Most private equity managers will offset a portion of the management fees they charge their limited partners with the fees they earn from their portfolio companies.

(8) Recalling and Recycling of Capital

It is common for private equity funds to contain provisions in their terms that permit them to recycle capital. Funds generally have the option to recycle capital in two situations. First, funds may have the ability to reinvest (i.e., “recycle”) the cost basis of investments realized within a certain time frame (typically 12 months from the date of initial investment). The ability to recall the capital for reinvestment is generally confined to the time period encompassing the investment period of the fund (typically the first 5-6 years of the partnership). Second, funds may have the ability to reinvest distributions up to the amount of management fees paid to the fund by its limited partners. It is important to note that recycling capital, in either case, has no impact on the amount of an investor’s original commitment to a private equity fund. Recycling capital has the practical effect of potentially increasing the amount of invested capital (above the investor’s capital commitment) without a commensurate increase in fees because fees are capped as a percentage of capital commitments—with capital commitments always remaining constant regardless of the ability to recycle. Recycling provisions may be beneficial to investors, as they enable investors to have additional capital at work, beyond their capital commitment, without an increase in fees (see Table below).

Assumptions

$1M Capital commitment
1.5% Management fee on the capital commitment during the investment period
The cost basis of investments realized within 12 months of the investment date can be reinvested within the fund’s investment period
The example below assumes the fund is still operating within its investment period

Hypothetical Example

$1M Capital commitment
$1M Capital called from investors ($1M is the maximum investor capital outlay)
$100k Recycled capital (re-invested cost basis of deals realized within 12 months of initial investment date)
$1.1M Total capital invested
1.36% Effective management fee on total capital invested assuming recycling of capital
1.50% Effective management fee without the ability to recycle capital

(9) Private Equity Cash Flows

In the early years of the life of a fund, the cash flows are predominantly negative for investors as cash is called by a partnership. In the latter years of a fund, cash begins to flow back to investors in the form of distributions from realized investments, assuming that portfolio companies are sold and profits are realized. The typical holding period for a portfolio company investment in a private equity fund is three to five years before it is realized. Prevailing economic and capital market conditions will also influence the holding period.