• Understanding Private Equity Funds – Everything You Need to Know

    Category: Private Equity Financing


    Private equity fund is a pooled investment from various private investors. Usually, investors bring along their funds and invest directly on private companies or business ventures or at other times, decide on buyout of public companies to facilitate a removal of a public equity.

    The funds pooled together for a private equity fund is commonly secured from retail or institutional investors. The collected funds are then used to fund fresh business ideas, new business or enterprise technologies, expand working capital of an existing company, make further asset acquisitions and the like.

    A person investing in a private equity fund is usually someone capable of committing large sums of money for long periods of time. As it is, private equity investments require long holding periods to facilitate a turnaround for a distressed company.

    Typically, most private equity funds are structures as limited partnerships. Usually, the setup would require that the partnership be supported by a general partner who raises capital from cash-rich investors like pension plan and insurance companies, colleges and universities, foundations or high net worth individuals. These investors are identified as limited partners in the equity fund.

    In this setup, it is normal that various components would first be agreed upon to establish the stake, claim and right of a limited partner. First of all, the term of the partnership is determined. On an average, this usually spans for ten years.

    Secondly, management fees are usually settled in the case of a private equity firm’s decision to use the fund as an investment for expansion or further wealth generation. In this case, the management fee is used to pay the fund manager or fund generator.

    Thirdly, as a matter of performance incentive (so as to increase the income-generation of the partnership, which is why partners invested in the first place), a carried interest is paid to the private equity fund’s management company. Here, a share of the profits of the fund’s investment is used.

    Since it is expected that the private equity fund would later yield into profit, at the onset, it must be settled upon that part of the transfer of an interest must be secured to the fund. Since private equity funds cannot be openly traded, usually, they may be transferred to another investor amongst the involved partners.

    It is most crucial during the legal structuring of the partnership, that the chosen fund manager be given enough power and discretion to conduct investments and control the affairs of the pooled fund. In this way, no influence by any limited partner may affect any investment option. Of course the fund manager would always have discussed restrictions, limitations and control which cancel out possibility of mismanagement of funds. In the end, it is important that restrictions on the General Partner be set.

    It may be perplexing how some business investors would decide on investing their money on a high-cost, long-bond, long-pay of Return of Investment type of investment. However, since the 1970s, there has been a growing trend in the United States for this kind of setup, as apart from fostering business relations and strengthening existing companies, it has opened opportunities for private investors to obtain rights to huge public companies they cannot acquire individually.

    Private Equity FAQ:

    Question: How do private equity firms operate?

    Answer: They raise money from investors and then buy equity in companies. They are negotiated deals not involving the stock market. Because they are private, there is no regulation. Frequently, they are providing startup capital or are buying a company that is in trouble. They make their money by either growing the startup or fixing the troubled company and then taking it public in about three years (they hope).

    Question: What’s the difference between private equity funds and hedge fund?
    I read in Business Weekly that pension funds, university endowments, and other big investors invest in hedge funds and private equity funds. An accompanying graph showed that private equity funds had much higher returns than hedge funds in 2006 and 2007, but also greater losses in 2008. What is the difference between the two? Do they invest in different products? If not, on what base would a pension fund choose whether to invest in one or the other?

    Answer: The two represent different asset classes, with their own returns cycles. The pension funds and other endowments seek exposure to different asset classes to diversify away their risks.

    Hedge Funds typically invest in publicly traded securities, currencies, derivatives, etc. and present some interesting strategies. There is a long list of these strategies, with names like portable-alpha, absolute-return, 130-30, long-short, stat-arb, and so on. But these are lightly supervised investment vehicles. Managers are incentivized by participation in profits beyond some hurdle. Their expertise is in markets, modeling, trading.

    Private Equity funds are more corporate finance/executives kind. They typically try to spot firms whose stocks may have fallen on harder times, or, more generally, whose market value (inclusive of takeover premiums) is way below the business value. They also buyout private companies when there is an opportunity such as cash crunch, business model change, death of a large holder, disputes, etc. They do buyouts, streamline the company, bring in better management, get rid of useless stuff, make it fit and attractive, and then resell to another buyer or re-IPO. They are ops/finance specialists, perhaps with some vertical-specific expertise.

    Question: Sometimes Private equity firms sell one of their investments back on the exchange Where can I see this?
    In other words where can you go to find a company that has recently come back to the exchange from a private equity firm or from becoming public?

    Answer: It would initially be listed as an IPO. You can check Yahoo Finance, stocks for the latest listings. If you have a specific company you want to know about check their web site.

    Question: Can someone explain the difference between Venture Capitalism and Private Equity?

    Answer: Venture capital is an investment meant to help get a promising company off the ground. Once the company has some track record of profitability and goes public, the vc’s make the bulk of their return, though they often chose to retain some ownership interest. VC is not angel investing, and does not usually provide seed capital. VC’s give the company cash to invest in itself, and the founders a bit of a payoff.

    Private equity is an investment where an investment firm takes a public company private, where it is solely owned by the fund’s investors. Typically, the goal is to clean up the balance sheet or management, and take the company public again a few years down the line.

    Question: What is the difference between a holdings company and a private equity firm?
    I mean Blackstone buys over companies and they are considered a private equity firm. But Berkshire Hathaway also buys over companies but they are considered a holdings company.

    Answer: Very simply put, a holding company owns 51% or more in the equity of another company (called its subsidiary). Holding companies are usually in for the long haul, and can exist for decades (think Coca Cola). Private equity firms invest in non-public companies and typically hold their investments with the intent of realizing a return within 3 to 7 years. Generally, investments are realized through an initial public offering, sale, merger, or recapitalization. Private equity groups tend to focus on more mature businesses, often contributing both equity and debt (or some hybrid) to the transaction. The firms were commonly called leveraged buyout firms (LBO) in the 1980s.

    Question: What is the specific differences between a Conglomerate and a Private Equity firm?
    What are the specific steps I should take in converting the business model from Conglomerate to a Private Equity firm in terms of organizational structure and primary activities.

    Answer: Conglomerates focus on operational issues while Private Equity firms focus on investments. Move from performance management towards valuation to be able to make the shift in business model. Finance skills should dominate over Operational skills.

    Question: If a company is purchased by a private equity firm what happens with the stocks?

    Answer: In general when a publicly traded company is purchased, the terms for existing shareholders are included in the deal. This usually means that shareholders will be paid a set amount of cash or shares in a related company.

    Question: How can a private equity fund introduce fresh capital in a Company it has acquired?
    If a private equity fund acquires 100% stake in a company with a deffered payment of final 25%, how can it introduce more capital in the company? What could be the threat with the resulting action for the fund and the old owners?

    Answer: Private equity fund had acquired this as for investment and not controlling stake as owners. As such they are not entitled directly infuse fresh capital of there own however they can ask management to pass resolution for fresh capital and then invest over there.

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