Private Equity Fund Meaning & Private Equity Fund Structure
Private Equity Meaning
A private equity fund is a collective investment plan in which funds and investors directly invest in companies or engage in buyouts of such companies. They are usually managed by a firm or a limited liability partnership that has a tenure of such funds that can be anywhere between 5-10 years with an option of annual extension.
A key feature of private equity funds is that the money which is pooled in for the purpose of fund investment is not traded in the stock market and is not open to every individual for subscription.
These are the leveraged buyout (LBO), and venture capital (VC.)
Leveraged Buyout (LBO) Model
Levered Buyout (LBOs) Models are the most common strategy in private equity. They use a lot of debt financing to acquire companies.
The leverage may come from bank loans, high yield bonds, or mezzanine financing.
Essentially, mezzanine financing is debt or preferred equity securities that are subordinate to high yield bonds. It typically has warrants or conversion rights that give investors an additional upside.
Leveraged Buyout (LBOs) Model Categories
Levered Buyout (LBOs) Models can be divided into two subgroups.
In Management Buyouts (MBO), the existing management team acquires a company with the help of a financial sponsor, usually a private equity firm; thus, they gain even more control over the business’s strategic direction.
For instance, management can implement major corporate actions in order to create value, which might be difficult if they don’t have full control over the company or the support of the majority of the shareholders.
In management buy-ins (MBI), a private equity firm buys a target company and brings in a new management team to replace the existing one.
This is done when an external management team is expected to implement new strategies that will increase the business’s value.
As the target company’s cash flows are used to repay buyout debt, Companies with high, stable, and visible cash flow generation are considered suitable for LBOs.
To create more value, private equity firms put in place management incentives like partial ownership in the business.
They can also implement strategic initiatives for cost reduction and revenue enhancement.
It provides funds to young companies with high growth potential, also known as startups or scaleups. Venture Capital allows investments in equity convertible shares or convertible debt.
The investment risk associated with venture capital is very high, as most startups fell before reaching maturity.
The ones that succeed, however, usually deliver very big returns.
Venture Capital funds are closely involved in the development of their portfolio companies. Usually, fund managers take board seats in these firms
Depending on the growth phase of companies invested in venture capital, investing can be divided into;
- Angel investing.
- Seed stage
- Later stage
- Mezzanine stage
Angel investing refers to the very first funding rounds of a business when it may be only at the idea phase.
Usually, financial from Angel Investors, also known as business angels, is used for preparing business plans and market potential assessment.
Investors are mostly high net worth individuals rather than funds.
Seed Stage Investments
Seed stage investments are typically used for market research, product development, and marketing. Not only business angels but also Venture Capital funds invest in seed funding rounds.
Early Stage Investments
It finances initial commercial production and sales.
Later Stage Venture Capital Funds
Invest in companies that already have production and cells and are trying to expand through increasing marketing activities.
Mezzanine VC Financing.
This refers to the timing of the financing rather than its type, as it is used when a company is preparing for an IPO.
It’s called mezzanine because it enters the firm’s capital structure during its transition from being a private organization to becoming a public company.
Categories of Private Equity Fund Strategies.
In a nutshell, However, there are also two smaller categories of private equity strategies.
Development Capital, (Minority Equity)
It is also known as minority equity investing. It provides capital for business growth or restructuring when done in public companies, called pipes or private investment in public equities.
This involves investing in the debt of mature companies in financial difficulties, such as default or bankruptcy. These investors are sometimes called vulture funds.
They work closely with the management of their portfolio companies to come up with a turnaround strategy and reorganization.
Private Equity Fund Structure
Similarly, to hedge funds, private equity funds are usually set up as limited partnerships. The capital provided by investors is called committed capital.
In general, it isn’t all drawn down or invested immediately, but gradually, as various investment opportunities are identified. The drawdown period is discretionary; however, it typically lasts from 3 to 5 years.
And how about the fees?
Alternative investment funds usually have management and incentive fees. Management fees of private equity funds are between one and 3% of committed capital than the invested capital.
Incentive fees are typically 20% of profits, so on average. We have the famous two and 20 fee structure, meaning a 2% management fee and 20% incentive fee.
However, before paying any incentive fees, the fund must return the investor’s initial capital. In some cases, at the end of the fund life, the total incentive fee may turn out to be higher than 20%.
This situation may occur when returns on portfolio companies are higher in the early stages of the fund life and decreased later on.
The solution for this pitfall is called clawback provisions. It requires the fund manager to return to investors in a surplus received in incentive fees above the agreed fee level.
Private equity funds hold their portfolio companies for five years on average. Then they sell them to realize returns. The main exit strategies are;
- A Trade Sell
- A Secondary Sell
- An IPO,
A trade sale
A trade sale is when a portfolio company is sold to a strategic buyer in a private deal.
A Secondary Sell
A secondary Sell is a variant of the strategy where a portfolio company is sold in a private deal to another private equity fund or a financial investor consortium.
Initial Public Offering (IPO)
The initial public offering, or IPO for short, is another common type of exit strategy.
As you know, this is the process of listing a company shares on a stock exchange where they’re sold to the public and traded as an I. P O makes the company public, which comes inevitably with many regulatory and disclosure requirements.
Next, we have recapitalization in this type of strategy. A given portfolio company takes on more debt to fund a dividend distribution to the private equity fund.
In this way, the fund can cash out partially and still retain control of the portfolio company. Thus, it is not a real exit, but an alternative to realizing returns and often a step towards an exit.
Write Off or Liquidation
Finally, there is the option of a write-off or liquidation. In such cases, a private equity owner would close down a portfolio company and lose that investment.
Key Benefits, Risks, And Due Diligence.
Over the last 20 years, private equity has recorded higher returns than the public stock market. It has also exhibited a lower correlation, suggesting diversification benefits.
Private equity returns have a higher standard deviation than the public stock market. That implies higher risk as private equity strategies such as LBO uses high leverage.
Investors should also consider the impact of interest rates and capital availability similarly to hedge funds. Private equity is often affected by survivorship and backfill bias.
When doing due diligence, Selecting the right fund manager or general partner is of key importance.
Investors should consider his or her track record, operating and financial experience, and expertise.
This is reflected in top quartile funds’ performance, which has significantly and consistently outperformed bottom-quartile funds over time.
Other factors to pay attention to during due diligence include the valuation methods, used fee structures, and drawdown procedures.