Private Equity 101

Hi,

I am new to private equity and am trying to grasp a couple of the concepts. would appreciate if you could help out.

1) How does a fund work? why is their multiple funds? can't you invest in another company if you still have money left from the fund?

2) I keep on seeing the word "equity check", what does that mean in the PE world

3) could you please describe what a shareholder loan is? what is the difference between the funds money?

4) what is funds of funds

5) what is a secondary fund

Thank you in advance

 
Best Response

Everyone has to start somewhere. Directing him to Google isn't too kind.

1) Private equity includes a range of strategies. The big ones are buyout (LBOs). growth equity, and venture capital. The difference comes down to (a) the stage of the company the fund invests in (e.g. startup or mature), (b) the market the company operates in (e.g. "middle market," generally agreed to be $50m-$1bn in revenue, or large-cap ($1b+)), and (c) the methods used to finance the investment (equity, debt, or a combination thereof).

There are multiple funds within a firm because each fund has its own lifecycle. A buyout fund typically has a 10-year lifespan broken into a 5-year investment period and 5-year harvest period. Those numbers might be 6/4 or even 7/3 depending on the strategy. (Growth equity and VC funds tend to skew the opposite way, 3/7 or 4/6. It makes sense intuitively, they're investing in businesses that take a longer time to return the investment.) Therefore, if Blackstone raises a $10bn fund in 2000, they have put all the money to work by 2005, and even though they have yet to fully recoup all the profits from the investments made (and will do so through 2010 [or longer if they extend the lifecycle]), they announce a new fund in 2005 in order to keep making investments.

2) "Equity check" refers to the amount of capital from the fund that a firm is putting into a deal. With LBOs, you "leverage" the investment by putting multiples of debt on top of your equity investment. For instance, a middle-market buyout might have transaction value of $500m. Of that $500, $100 is equity and $400 is debt. There are four "turns" of debt, or 4x. (In today's environment, leverage is generally lower.) This improves the return profile. If your fund is $10bn and you could only use equity, the total value of all transactions you do out of that fund is $10bn. With leverage, however, it can be much higher ($30-50bn depending on market conditions and your ability to secure debt financing).

3) This one is easily Google-able. Shareholder loans are a debt-like form of financing provided by shareholders. it's often the most junior debt in the company, has a long maturity with low or deferred interest payments, and generally improves a company's capital structure by lightening the debt load. It's a common instrument in buyouts to control the degree of leverage.

4) A fund-of-funds is a firm that invests in other funds. The model is the same; every few years a new fund is raised (and each one has a pre-appointed investment period and harvest period). The strategy can vary, however. Some fund-of-funds are multi-asset, meaning they diversify across hedge, long-only, private equity (buyout, growth, venture), real estate, real assets, and fixed income funds. Others specialize in a single asset class, focusing solely on one of the above. They charge lower fees (not the "2 and 20" that direct fund managers charge).

5) A secondary fund is a fund-of-funds that buys existing LP interests in a fund from an LP who wants liquidity. For instance, say CALPERS or the NYS Common fund gets a new CIO. He decides he cannot stand venture capital, he thinks it's too risky and the return profile is unattractive. In his first month on the job he discovers that their portfolio includes $5bn in commitments to 80 different VC funds.

Each of those funds is at a different stage in their lifecycle. A bunch are in the first or second year (and therefore have barely begun deploying capital). Some are in the fourth or fifth year and therefore have deployed the majority of their capital but have not yet distributed returns to LPs. Some are in the eighth or ninth year and have distributed substantial returns to investors.

That's clearly a messy situation (the CIO deciding to get out of all those fund relationships). A secondary fund is a party who takes the effort to calculate the value of all those LP commitments, evaluating where they are in the capital call schedule, what portion of the commitment remains unfunded, and what kind of distributions have already been made. After that evaluation, they calculate a value for the LP commitment in that fund and make an offer to the existing LP (CALPERS/NYS Common in our example). CALPERS gets a lump sum payment for whatever LP relationship the secondary fund buys from them, and everyone is happy.

One note to make is that a lot of GPs have restrictive clauses in their subscription documents that limit whether or how LPs can transfer their commitments to another party in the secondary market. Not every GP is eager or open to the idea of someone they don't know now being an LP in their fund instead of the LP they already know and have a relationship with.

Some further links that might be helpful (I have no idea how on this new forum version to format these to make them pretty): https://en.wikipedia.org/wiki/Private_equity_fund https://en.wikipedia.org/wiki/Middle-market_company https://en.wikipedia.org/wiki/Private_equity_secondary_market http://dealbook.nytimes.com/2015/02/18/a-boom-in-private-equitys-second… http://www.interviewprivateequity.com/what-is-private-equity/

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