Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

An Introduction to Private Equity

Private equity is one of the most commonly discussed alternative investments, and it may also be one of the least understood.  Broadly defined, private equity is any ownership in a company that isn’t publicly traded on an exchange, but this definition does little to explain what is generally referred to as private equity.  This post will be the first in a series about private equity, explaining how investments in private equity generally are structured and describing the common mechanics of these funds.

Private equity investments are normally organized in the form of a partnership.  The private equity investment company (some well known examples of these firms are The Blackstone Group, Bain Capital, KKR, and Apollo Management) assumes the role of general partner (GP).  The GP acts as the fund manager, collecting capital, directing the investment, and eventually distributing any profits.  Investors in the fund are limited partners (LPs) who have no voting power with respect to the investment strategy of the fund, but also carry only limited liability (meaning they can lose no more than their initial investment).  LPs commit a certain amount of capital to the fund, knowing that the capital may or may not be called depending on how the GPs view investment opportunities.

GPs will create a specific closed-end fund or “vintage fund” with a pre-specified lifetime (generally 10-12 years with a possible option for an extension).  For example, a fund could be created next year as a “2014 fund” which was scheduled to close by 2024.  In the early years of the fund, the GP would request the committed capital from the investors (known as making capital calls) as they found investments they wanted to make.  Typically all the capital calls must be completed by the third year, at which point all called money should be invested.  As investments mature and begin to generate profits, cash distributions are made to the LPs (net of the managers’ fees).  At the end of the fund’s lifetime, all investments are sold or otherwise divested, and the remaining money is distributed accordingly among the investors.  This process of initially calling money from investors and eventually returning it generates a return structure known colloquially as a “J-curve.”  An example of this return pattern can be seen in the following graph of a theoretical fund performance.

PE graph

Returns from private equity are measured over the life of a fund, and are calculated as the internal rate of return (IRR) of the cash flows of that fund.  Due to the vintage fund structure, it is difficult to evaluate the performance of a private equity investment until the fund has been wrapped up and the assets distributed among the partners.  Before any money is returned to LPs, the GP will subtract their management fee, which tends to be about “1 and 10,” or 1% of assets under management (annually) and 10% of any profits generated.  Some funds will charge as much as 2% and 20%, or even more depending on investor demand, but this is less common in private equity than it is in hedge funds.  This fee structure can be a high hurdle for investors to overcome in order to make a risk-adjusted return in excess of that generated by publicly traded equity.

Another risk factor involved in private equity investments is the inherent illiquidity of the fund structure.  Once a fund has begun, there are typically large penalties for withdrawing money before the fund has closed out.  This means that an investor’s money is essentially locked up for the entirety of the life of the fund.  Most private equity funds have relatively high minimum investments as well, typically anywhere from $100,000 to $500,000 per investor, which, coupled with the illiquidity of the invested assets, can make private equity a particularly risky investment for smaller investors.

This lack of liquidity makes the value of a private equity investment difficult to assess during a fund’s lifetime.  Occasionally fund managers will have the fund value appraised to provide some guidance to investors, but this is an estimate, and thus an imperfect measurement of value.  Also, the infrequency of return reporting has the effect of smoothing apparent returns, which can distort estimates of the volatility of these investments.  These risks, which do not exist in publicly traded equity, must be considered by anyone considering investment in private equity.

This post is intended to provide an introduction into the fund structure that is most commonly used in private equity.  The remaining articles in this series will describe in greater detail the primary types of private equity investments available.  The strategies covered will include:

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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    […] discussed in the previous post1 in this series, private equity firms gather investors and organize capital in the form of a […]

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