This guest post was written by Efraim Landa
Efraim Landa is a venture capitalist and the founder of Effi Enterprises.
When talking about a private equity fund, usually they tend to be partnerships that have been formed by a PE firm. Private equity funds can either be for general investments of businesses or they can also fund in different industries. Most of the equity funds you see these days last around 10-13 years, which is usually an entire term, but they do vary by business. When you get a private-equity fund the fund is closed when you the business have distributed all the funds back into the account for the partners of the fund. As you can see this is a very useful and efficient way to get money for something like a small business or start-up, but they tend to be difficult to get unless you have a projected plan of action to show the partners you would/could/will make money from the business so that they can get their money back. Private Equity funds tend to focus on one of the following:
Venture Capital: This is used when a company is at the early stages of development and they need extra cash, but they cannot get access to something like conventional markets in financing.
Growth Capital: This is used when a company or business is already started but needs extra funds to grow the business further i.e.; an expansion, another franchised business, etc.
Management Buyouts: This happens when a company has an existing management team who would take control of the business in question.
Distressed Situations: This happens, as it has happened often over the past 1 years when a company has debt and needs a way to get out of debt.
What Is Private Equity?
According to Wikipedia “A private equity fund is a collective investment scheme used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity. Private equity funds are typically limited partnerships with a fixed term of 10 years (often with annual extensions). At inception, institutional investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund. From the investors’ point of view, funds can be traditional (where all the investors invest with equal terms) or asymmetric (where different investors have different terms).”
The private in private equity deals with privately owned and traded stakes in various companies that are not subsequently subjected to the public market. These companies are also usually free from certain regulations like federal securities. Private equity includes all sorts of types, including venture capitalist firms, buyout firms and as mentioned above, growth equity firms. A Private Equity fund tends to have two major parts – the GP or General Partner and the Limited Parties – the LP are who the funds are procured by. Limited Partners are not just limited to firms, though, you also have a lot of wealthy individuals that are interested in funding businesses and they can become Limited Partners.
The GP on the other hand, may not put as many funds into the investment, but they will usually put a small amount in, they also do other things like deal with arranging loans from the bank. GPs and LPs are such an important part of an equity fund because between the two, they make up the entire equity of the investment, this is also the reason they have so much power and control of the acquired business.
How Does Private Equity Work?
General partners help to raise capital from LPs. There are key terms to these firms, and you can see the stats below as well as some definitions that are important in this situation:
Targeted investor returns: 30% internal rate of return (IRR) (More likely in the mid-20s due to the global financial crisis and intensifying competition in private equity)
Investor commitment: 10 years
Portfolio company investment horizon: 3 to 5 years (and up to 7 years for some firms; longer investment periods will become more typical especially in light of the global financial crisis)
Annual management fee: 1% to 2% of committed capital (typical fee of 2% is falling to 1.4% and possibly lower given the global financial crisis)
Profit split: Capital gain profit split of 80% to the investors and 20% to the GPs (also known as 80/20). Distribution of proceeds: Investors receive their invested capital offset by any bad investments plus 8% to 9% on the total invested capital (also known as the preferred return or hurdle rate) along with any fees paid by the investors, (ii) If there are proceeds after the hurdle rate, the profits are split where the investors receive 80% and GPs receive 20% of the net overall fund profits (GPs 20% is also known as carried interest or carry).
Claw back: Requires private equity firms or GPs to return distributions of carried interest to the extent of any subsequent losses in other investments of the fund. In other words, if the private equity firm generates losses on some investments, it shares in the downside because its carry from other successful investments is offset by the deals gone sour.
Obviously in some situations, a company would rather use another type of equity or a way to get funds, but equity funds are by far and wide one of the most used options when it comes to financial well-being of a company.