Sep 20, 2023
Private equity significantly differs from the more conventional investment classes like stocks and bonds. Engaging in this market demands more from investors and can appear intricate to navigate.
Moreover, the unlisted sector lacks the regulations of the publicly listed market, where companies face stringent reporting requirements. This results in an absence of standardized practices for reporting and metrics calculation within private equity funds.
As a result, the private equity market remains less transparent than its publicly listed counterpart, complicating a comprehensive assessment of investments in this area.
Continue reading to gain a clearer understanding of private equity.
Private equity investments constitute a type of asset class – similar to securities such 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 fund invests in a collection of private companies, with the aim of nurturing their full potential for growth and subsequently selling them for profit. Therefore, it's essentially these funds that you invest in.
This process involves committing to invest a specific amount in the fund. You don't pay the amount immediately; instead, you provide a capital commitment – known as a 'commitment' in the private equity world – which remains binding throughout the fund's lifespan. This means that the fund can 'call' the money when they require 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 potential returns.
The minimum commitment threshold for an investor with most funds is $150,000, and the investment horizon typically spans 8 to 10 years. 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.
As a result, the primary investors in private equity have so far been professionals and institutional entities like pension funds, family offices, corporations, and funds. However, in recent years, this asset class has been witnessing a significantly rising interest from private affluent individuals. They view this investment type as yet another opportunity to pursue returns while simultaneously diversifying their wealth across various investment types.
When embarking on private equity investment, investors often decide what portion of their overall investments should be allocated to this asset class. However, achieving a consistent allocation over time can be challenging. This is because you've actually allocated to the asset class only your share of the fund's actually invested capital, not the committed capital. It can be quite difficult to predict when the fund will initially invest in and subsequently sell companies. It also frequently occurs that a fund doesn't call for 100% of your commitment.
Some investors thus 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.
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, responsible for raising capital from investors and managing the funds that invest in various unlisted companies. Limited Partners are the investors who have committed capital to the fund.
The decision-making authority concerning investments lies solely with the GP. 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.
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 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, thus 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.
LPs in a fund can’t risk losing more money than they have 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 GP.
Understanding the lifecycle of funds is crucial for several reasons. First and foremost, it's essential to gain insight into their operations before deciding to invest in private equity. Furthermore, it provides foundational knowledge necessary for evaluating your investments. Many of the key metrics in fund reporting evolve based on the fund's position within its lifecycle.
A fund typically follows an 8-10 year lifecycle, consisting of the following four phases:
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.
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. This might include investing in companies within a specific industry or geographic area.
As the name implies, private equity funds often invest in private, unlisted companies. However, they might 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.
In the third phase, the fund aims to increase the value of acquired companies. The approach varies depending on the fund type.
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.
As the companies mature and hopefully can be sold at a profit, they are sold.
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.
There are numerous types of private equity funds, differing in investment strategies. The two most popular types are buyout funds and venture funds.
Buyout 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.
In contrast to buyout 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.
Maintaining a clear view 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. We ensure that 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.
Creating a comprehensive private equity overview is not as simple as just compiling the key figures from the different funds you have invested in. In this article, we look into what you should be aware of when creating an overview of your private equity investments.
Jul 19, 2023
ESG (Environmental, Social and Governance) and Sustainable Investments are among the significant topics of discussion in the financial world, where more and more investors express a desire to align their investments with their values.
Jun 06, 2023
Do you know if your returns are good enough?
May 11, 2023