Private equity

Private equity is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. Passive institutional investors may invest in private equity funds, which are in turn used by private equity firms for investment in target companies. Categories of private equity investment include leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others. Private equity funds typically control management of the companies in which they invest, and often bring in new management teams that focus on making the company more valuable.

Private equity refers to shares in companies that are not listed on a public stock exchange; while technically the opposite of public equity they are broadly equivalent to stocks, though return on investment often takes much longer. As they are not listed on an exchange, a private equity firm owning such securities must find a buyer in the absence of a traditional marketplace such as a stock exchange. The "exit" or "selling out" is often done by the way of an initial public offering (IPO), i.e. floating the company on a stock exchange. In addition, there are many transfer restrictions on private securities.

Private equity funds

Private equity funds are the pools of capital invested by private equity firms. Although other structures exist, private equity funds are generally organized as limited partnerships which are controlled by the private equity firm that acts as the general partner. The limited partnership is often called the "Fund", and the general partners are sometimes designated as the "Management Company" (although at times, that is a separate company affiliated with the general partner). The fund obtains capital commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at which time each limited partner funds a pro rata portion of its commitment. All investment decisions are made by the General Partner which also manages the fund's investments (commonly referred to as the "portfolio"). Over the life of a fund which often extends up to ten years, the fund will typically make between 15 and 25 separate investments with usually no single investment exceeding 10% of the total commitments.

General partners are typically compensated with a management fee, defined as a percentage of the fund's total equity capital. In addition, the general partner usually is entitled to "carried interest", effectively a performance fee, based on the profits generated by the fund. Typically, the general partner will receive an annual management fee of 2% to 4% of committed capital and carried interest of 20% of profits above some target rate of return (called "hurdle rate"). Gross private equity returns may be in excess of 20% per year, which in the case of leveraged buyout firms is primarily due to leverage, and otherwise due to the high level of risk associated with early stage investments. Although there is a limited market for limited partnership interests, such interests are not freely tradeable like mutual fund interests.

Private equity firms generally receive a return on their investment through one of three ways: an IPO, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.

Considerations for investing in private equity funds relative to other forms of investment include:

Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $100,000) plus further investment for the first few years of the fund called a 'drawdown'.

Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.

If the private equity firm can't find good investment opportunities, they may end up returning some of your capital back to you. Given the risks associated with private equity investments, you can lose all your money if the private-equity fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which back young companies in the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.

Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.

For the above mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds.

Most private equity funds are offered only to institutional investors and individuals of substantial net worth. This is often required by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US, most funds require potential investors to qualify as accredited investors, which requires $2.5 million of net worth (exclusive of primary residence), $200,000 of individual income, or $300,000 of joint income (with spouse) for two documented years and an expectation that such income level will continue.

Some examples of private equity owned organisations are Debenhams (a major UK based clothing retailer) and Jimmy Choo (high-end ladies shoes).

Private equity fundraising

Private equity fundraising refers to the action of private equity firms seeking capital from investors for their funds. Typically an investor will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself. As a result, an investor will only benefit from investments made by a firm where the investment is made from the specific fund that they have invested in.

The majority of investment into private equity funds comes from institutional investors. The most prolific investors into private equity funds in 2006 were public pension funds and banks and financial institutions, which together provided 40% of all commitments made globally according to data from London-based Private Equity Intellligence Ltd. Other prominent groups investing in private equity include corporate pension plans, insurance companies, endowments, family offices and foundations.

Another large investor group in private equity funds are so-called fund of funds, which are private equity funds that invest in other private equity funds in order to provide investors with a lower risk product through exposure to a large amount of vehicles often of different type and regional focus. Fund of funds accounted for 14% of global commitments made to private equity funds in 2006 according to Private Equity Intelligence Ltd.

As fundraising has grown over the past few years, so too has the number of investors in the average fund. In 2004 there were 26 investors in the average private equity fund, this figure has now grown to 42 according to Private Equity Intelligence Ltd.

It is also worth noting that the managers of private equity funds themselves will also invest in their own vehicles, typically providing between 1% - 5% of the overall capital.

Often private equity fund managers will employ the services of external fundraising teams known as placement agents in order to raise capital for their vehicles. The use of placement agents has grown over the past few years, with 40% of funds closed in 2006 employing their services according to Private Equity Intelligence Ltd. Placement agents will approach potential investors on behalf of the fund manager, and will typically take a fee of around 1% of the commitments that they are able to garner.

The amount of time that a private equity firm spends raising capital varies depending on the level of interest amongst investors for the fund, which is defined by current market conditions and also the track record of previous funds raised by the firm in question. Firms can spend as little as one or two months raising capital where they are able to reach the target that they set for their funds relatively easily, often through gaining commitments from existing investors in their previous funds, or where strong past performance leads to strong levels of investor interest. Other managers may find fundraising taking considerable longer, with managers of less popular fund types (such as European venture fund managers in the current climate) finding the fundraising process more tough. It is not unheard of for funds to spend as long as two years on the road seeking capital, although the majority of fund managers will complete fundraising within nine months to fifteen months.

Once a fund has reached its fundraising target, it will have a final close. After this point it is not normally possible for a new investor to invest in the fund, unless they were to purchase an interest in the fund on the secondaries market.

Size of industry

Nearly $135bn of private equity was invested globally in 2005, up a fifth on the previous year due to a rise in buyouts as market confidence and trading conditions improved. Buyouts have generated a growing portion of private equity investments by value, and increased their share of investments from a fifth to more than two-thirds between 2000 and 2005. By contrast, the share of early stage or venture capital investment has declined during this period. Private equity fund raising also surpassed prior years in 2005 and totalled $232bn, up three-quarters on 2004.

Prior to this, after reaching a peak in 2000, private equity investments and funds raised fell in the next couple of years due to the slowdown in the global economy and declines in equity markets, particularly in the technology sector. The fall in funds raised between 2001 and 2003 was also due to a large excess created by the end of 2000 of funds raised over funds invested.

The regional breakdown of private equity activity shows that in 2005, North America accounted for 40% of global private equity investments (down from 68% in 2000) and 52% of funds raised (down from 69%). Between 2000 and 2005, Europe increased its share of investments (from 17% to 43%) and funds raised (from 17% to 38%). This was largely a result of strong buyout market activity in Europe. Asia-Pacific region’s share of investments increased from 6% to 11% during this period while its share of funds raised remained unchanged at around 8%. ^[1]

Private equity fundraising reached new record levels in 2006, with data from Private Equity Intelligence showing that a total of 684 funds worldwide achieved a final close over the course of 2006, raising an aggregate $432 billion in commitments.

The biggest fund type in terms of commitments garnered was buyout, with 188 funds raising an aggregate $212 billion. So-called mega buyout funds contributed a significant proportion of this amount, with the ten largest funds of 2006 raising $101 billion alone – 23% of the global total for 2006. Other strong performers included real estate funds, which grew 30% from already strong 2005 levels, raising an aggregate $63 billion globally. The only fund type to not perform so well was venture, which saw a drop of 10% from 2005 levels.

In terms of the regional split of fundraising, the majority of funds raised in 2006 were focusing on the American market, with 62% of capital raised in 2006 focusing on the US. European focused funds account for 26% of the global total, whilst funds focusing on Asia and the Rest of World account for the remaining 11%.

Venture Capital is considered a subset of private equity focused on investments in new and maturing companies.

Mezzanine capital is similar class of alternative investment focused on structured debt securities in private companies.

Private equity fund performance

In the past the performance of private equity funds has been relatively difficult to track, as private equity firms are under no obligation to publicly reveal the returns that they have achieved from their investments. In the majority of cases the only groups with knowledge of fund performance were investors in the funds, and the firms themselves, making comparisons between various different firms, and the establishment of market benchmarks to be a difficult challenge.

The introduction of the Freedom of Information Act (FOIA) in the United States and other countries such as the UK in the early 21st Century, has led to performance data for the industry becoming more readily available. Following the introduction of the new FOIA legislation, London-based research and consultancy firm Private Equity Intelligence used the Freedom of Information Act in order to request data on private equity fund performance from bodies such as public pension funds, establishing a online searchable database of private equity fund performance which currently shows data for more than 3,000 funds using data from Freedom of Information Act requests, and also in a large number of instances data from fund managers themselves.

It is also possible to view private equity performance data directly on the websites of certain investors. For example, the California Public Employees’ Retirement System which is amongst the most prolific investors in the asset class in the world, gives considerable levels of information regarding performance.

The performance of the private equity industry over the past few years differs between funds of different types. Buyout and real estate funds have both performed strongly in the past few years in comparison with other asset classes such as public equities, certainly a factor in the bumper fundraising that both have enjoyed of late. In contrast other fund types such as venture have had not shown such a strong overall performance. Manager selection in the private equity industry is definitely a vital factor for any investor seeking exposure to the market, with the performance of the top and bottom quartile managers varying dramatically, especially so in the high-risk venture capital world, and less with so with real estate funds for example.

Liquidity in the Private Equity Market

The private equity secondary market (also often called private equity secondaries) refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds. Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. For the vast majority of private equity investments, there is no listed public market; however there is a robust and maturing secondary market available for sellers of private equity assets.

Driven by strong demand for private equity exposure, a significant amount of capital has been committed to dedicated secondary market funds from investors looking to increase and diversify their private equity exposure.

Major secondary specialist firms include: Coller Capital, Landmark Partners, Lexington Partners, AlpInvest Partners, Goldman Sachs, Partners Group and Credit Suisse as well as smaller firms including Adams Street Partners, Pomona Capital, Pantheon Ventures and Paul Capital.

Advisors of secondary sellers include UBS Investment Bank (UBS AG) as well as dedicated boutique firms Cogent Partners, Probitas Partners, Campbell Lutyens, Capstone, NYPPE and Triago-X.

Related Subjects

References

^ http://www.ifsl.org.uk/uploads/CBS_Private_Equity_2006.pdf

External links

[1] ttp://www.ifsl.org.uk/uploads/CBS_Private_Equity_2006.pdf

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