What is private equity?

Private equity significantly differs from more conventional investment classes like stocks and bonds. Engaging in this market demands more from you as an investor, and it can be intricate to navigate.

Jan 03, 2024

Private equity

Ken Gamskjær

CEO and Founder

Family offices now hold more private assets than they do publicly traded stock.

All of 29.2% of their investments are allocated to the private markets.

That's according to the new study on North-American family offices performed yearly by Campden Wealth and RBC. And the study shows no signs that this trend is about to discontinue;

"41 percent of family offices have intentions to increase their allocation to private equity funds, while 32 percent plan to bolster their investments in direct private equity."

And it's not just family offices, but an increasing number of investors in general who are turning towards alternative asset classes such as private equity in their quest for returns and to diversify their portfolios.

But what is private equity?

The answer is not that simple, I'm afraid, but I'll explain it to you in this article.

You see, private equity significantly differs from more conventional investment classes like stocks and bonds. Engaging in this market demands more from you as an investor and can be intricate to navigate. There are many things to consider before investing in this asset class.

While there are quite stringent reporting rules for companies in the public market, the unlisted private market is a bit more wild west-ish with no standardized practices for reporting and metrics calculation within private equity funds.

All this means that the private market is less transparent than its public counterpart which makes it more difficult to maintain an overview of and evaluate your private equity investments.

But fear no more.

Through our series of private equity articles, we aim to guide you through this popular asset class, step by step.

In this article, I'll start with the basics to establish a strong foundation before delving into other topics in the following articles, some more complex than others.

What is private equity?

Private equity is a type of asset class just as stocks, bonds, and real estate.

When investing in this asset class, it typically involves engaging through a company dedicated to establishing and managing a number of private equity funds. Each of those funds then invests in private companies, with the aim of nurturing their full potential for growth and subsequently selling them for profit. So essentially you're investing in these funds. (If this sounds confusing, don't worry. We'll get more into this Russian-doll-like structure in just a moment.)

When you invest in private equity, you commit a specific amount of money to the fund. You don't pay this commitment upfront; instead, you provide an official capital commitment – simply known as a commitment in the private equity world – which remains binding throughout the fund's lifespan. In return, you receive limited partnership units in the fund.

The fund can now call part of the money when they need capital for acquiring new companies or covering expenses. The portion of your commitment that you haven't fulfilled yet is referred to as your unfunded commitment.

It's not until the fund sells the companies that you and the other investors realize the potential returns from investing in the fund.

The commitment threshold to invest in a private equity fund is usually minimum $200,000, but it can be millions. And the investment horizon typically spans 8 to 10 years, but it can also be longer. This means you have to be prepared to commit part of your wealth to illiquid investments for quite some time.

This extended period is necessary for the funds to secure capital from investors, acquire or invest in chosen companies, nurture growth within those companies, and eventually sell them.

Over-commitment

When investors enter the private equity market, they often decide how big a portion of their overall investments they want to allocate to this asset class. However, achieving a consistent allocation in private equity over time can be challenging.

Why?

Because: as explained, when you invest in a private equity fund, you make a capital commitment, but not all of that capital is invested from the outset, nor at the same time. It also often happens that a fund doesn't even call for all 100% of your commitment.

It's quite difficult for you as an investor to predict when and how much of your commitment the fund will invest and thereby how much of your total wealth is, in fact, invested in this asset class and not just committed to it.

To mitigate this issue, some investors adopt an over-commitment strategy where, across the funds they've invested in, they commit to a higher amount than their strategy dictates for allocation. Various methods exist to estimate how much and when one should commit to achieve a smooth and continuous allocation to the asset class. However, theory and practice don't always align, presenting one of the challenges tied to this type of investment.

Simultaneously, remember that you need the liquidity readiness to fulfill your total commitment at any given time, as failing to meet capital calls from a fund can have significant repercussions.

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How is the structure and role distribution in a private equity fund?

Roles

Members of a private equity fund can broadly be divided into two parties – a General Partner (GP) and a group of Limited Partners (LP). The General Partner is the private equity firm through which you invest in the private equity funds. The General Partner is responsible for raising capital from investors and managing the funds that invest in various unlisted companies. The Limited Partners are the investors who have committed capital to the fund.

It's the General Partner, the private equity firm, that has all the decision-making authority, meaning only they decide which companies to invest in. Once you've committed as an investor, you have no influence over which specific companies the fund invests in. This is why private equity funds are often referred to as blind pools.

Note: However, it's essential for you as an investor to continually monitor your private equity investments. You must always be aware of your total unfunded commitment, as funds can call for this at any time, and not meeting capital calls can have significant repercussions. Additionally, evaluating the fund's performance can also be a tool for assessing whether you want to invest in new funds that the same GP might establish in the future.

Consequences of not meeting capital calls

If you miss a capital call from one of the funds you've invested in, you'll typically have a predetermined limited period to fulfill the call with a delay, and the fund will usually have the right to demand an interest for the late payment.

If you still don't meet the call within this period, it will often have severe consequences. For instance, the GP might gain the right to resell your share of the fund. The GP could also have the option to strip you of your share in the fund, and thereby exempting you from future capital calls. However, this action would also reduce the fund's total commitments and consequently its management fee. As such, the GP doesn't always choose to exercise this option. Additionally, you might be liable for the costs the GP incurs in managing your missed capital call.

As such, depending on the fund's stage in its lifecycle, not being able to meet a capital call can have significant financial implications for you, regardless of the reason. Conversely, these stringent rules are also designed to safeguard you against other investors in the fund missing their calls, which could potentially diminish the fund's total commitment.


Risk and Responsibilities

Limited Partners in a fund can’t risk losing more money than they've committed to the fund, as they are only liable for that specific amount. If the fund were to lose all of its capital due to failed investments and end up in debt, the sole responsibility for repaying this debt lies with the General Partner.

The lifecycle of a private equity fund

Understanding the lifecycle of private equity funds is crucial for several reasons. First and foremost, it's essential that you have an understanding of how these funds work before deciding to invest in the asset class.

Furthermore, you won't be able to evaluate your private equity investments without a good understanding of their lifecycle. This is because many of the key metrics in fund reporting evolve based on how far the fund is in its lifecycle.

A fund typically follows an 8-10 year lifecycle, consisting of the following four phases:

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1. Fundraising and establishment

In the initial phase of the fund's lifecycle, the primary task of the company behind the fund is to secure investors (Limited Partners) for the fund. Once enough capital has been raised, the fund is established, and investors become definitively committed. The company then continues to raise capital until they reach the desired amount.

As mentioned, investors commit to investing a specific amount, which they don't pay immediately. Instead, they provide a commitment, allowing the fund to 'call' the money when they need capital for investments or covering expenses.

If you invest in multiple funds, it's crucial to keep track of your total unfunded commitment, as you might need to meet capital calls from several funds simultaneously. Failing to meet a capital call for any reason can have significant consequences as explained further above.

2. Selection and investment in companies

Once the desired capital is raised, it's time for the fund to identify attractive companies and negotiate purchases with their owners. Often, funds invest in companies with shared characteristics, such as industry or geographic area.

As the name implies, private equity funds often invest in private, unlisted companies. However, they can actually also invest in publicly listed companies and then delist them. When a fund owns a significant portion of a company, they can carry out a forced delisting.

3. Value creation in portfolio companies

In the third phase of its lifecycle, the fund works on increasing the value of its portfolio companies. How they do it depends on which kind of private equity fund it is.

Some funds acquire a majority stake in companies, allowing them to make changes to aspects like strategy, structure, or leadership composition. Other funds focus on contributing to the companies' success through mentoring, networking, and capital infusion.

4. Exit and distribution of gains

As the companies mature the goal is to sell them at a profit.

An exit is influenced by circumstances surrounding each individual company – the goal is to sell at the most opportune time.

Immediately after an exit, investors receive their share of the profits from the sale of the company.

Types of private equity funds

There are numerous types of private equity funds, differing in investment strategies. The two most popular types are capital funds (buyout funds) and venture funds.

Capital funds (buyout funds)

Capital funds acquire established companies lacking the necessary capital to unlock their full potential. These companies are often stable, non-cyclical businesses with a reliable cash flow. Stability is crucial for buyout funds, as they either borrow up to 80% of the acquisition price from a bank – using the acquired company's assets as collateral, which they repay through the company – or they finance 80% of the acquisition price through leveraged loans. The remaining portion of the purchase price is covered using the fund's own resources.

Venture funds

In contrast to capital funds, venture funds invest in smaller, new companies at the early stages of their lifecycle, often comprising only a promising business idea. The key criterion is that these companies are deemed to possess significant growth potential, strong leadership, and a unique product.

Given the companies' stage of development, there is relatively high risk associated with investing in them. However, this risk is balanced by the possibility of achieving substantial returns if the company succeeds.

Get a comprehensive and reliable overview of your private equity investments

Maintaining a clear overview of your total unfunded commitment and investment outcomes can be challenging in the realm of private equity.

One of our areas of expertise is private equity reporting. With our wealth platform, Aleta, you're always aware of precisely how much various funds can call from you and what their performance has been. This equips you with the clarity and understanding needed to make informed decisions for your investments.

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