Understanding Private Equity | CFA Level I Alternative Investments
Private equity refers to investments in privately owned companies or public companies with the intent to take them private. These investments are usually categorized by their investment strategy, which includes leveraged buyouts, venture capital, and development capital.
Leveraged Buyouts (LBOs)
A leveraged buyout involves acquiring established private or publicly listed companies, with a significant percentage of the purchase price financed through debt. Publicly listed companies are taken private after the buyout. For a leveraged buyout to be successful, two key criteria must be met:
- The target firm must have the potential for an increase in value through management incentives, restructuring, cost reduction, or revenue enhancement.
- Debt financing must be available for a highly leveraged purchase.
Two types of LBOs are management buyouts and management buy-ins.
Venture Capital
Venture capital funds invest in companies in the early stages of development, often in the form of equity, convertible preferred shares, or convertible debt. Venture capital investments can be categorized based on the company’s stage of development:
- Angel investing: Capital provided at the idea stage, often by individuals rather than venture capital funds.
- Seed stage financing: Investments made for product development, marketing, and market research.
- Early stage financing: Provided to companies moving toward operation but before commercial production and sales have occurred.
- Later stage: The stage where a company already has production and sales and is operating as a commercial entity.
- Mezzanine-stage financing: Capital provided to an established company to prepare it for an IPO.
Development Capital
Also called minority equity investing, development capital earns profits from funding business growth or restructuring. Such financing is referred to as Private Investment in Public Equities (PIPEs).
Exit Strategies
Private equity funds aim to improve new or underperforming businesses and exit them at high valuations. Some common exit strategies include:
- Initial Public Offering (IPO): Selling all or some shares of the portfolio company to the public.
- Trade Sale: Selling the portfolio company to a strategic buyer, such as a competitor.
- Secondary Sale: Selling the portfolio company to another private equity firm or group of investors.
- Recapitalization: The company issues debt to fund a dividend distribution to equity holders, including the private equity fund.
- Write-offs and Liquidation: Writing off some assets to their fair value or liquidating the entire portfolio company if it fails to perform well.
These exit strategies can be pursued individually, combined, or used for a partial exit strategy.
Private Equity: Risk vs Reward
Historically, private equity funds have offered higher returns compared to traditional investments, thanks to factors like their ability to invest in private companies, influence operations, and use leverage. Additionally, private equity returns show less-than-perfect correlation with traditional investments, which means they can add diversification benefits to a traditional portfolio.
However, critics argue that private equity returns data may be overstated due to biases such as survivorship and backfill. Furthermore, private equity funds appear to be riskier than reported, as their return correlations and standard deviations may be biased downward.
It’s crucial to choose skilled fund managers in private equity since there’s a significant difference between top and bottom quartile funds, and their performance rank shows persistence over time.
Private Equity Fee Structures
Similar to hedge funds, private equity funds are often structured as limited partnerships, with Limited Partners (LPs) as outside investors and the private equity firm as the General Partner (GP). Most private equity firms charge both a management fee (1-3%) and an incentive fee (typically 20%).
Unique to private equity is the concept of committed capital, which refers to the amount that LPs agree to provide the fund. The committed capital stays with the LPs until the private equity fund draws from it for identified investment opportunities. Committed capital that hasn’t been drawn down is called “dry powder.”
EXAMPLE
Let’s say a private equity fund has $10 million in committed capital. Initially, the GP draws down $3 million for an investment, leaving $7 million in dry powder. The management fee is calculated based on the total committed capital of $10 million (not just the invested amount). If the management fee is 1%, the GP receives $100,000 per year.
Once the committed capital is fully invested, management fees apply only to the remaining funds in the investment vehicle. As investments are exited and capital returned to investors, they no longer pay fees on that portion of their investment.
Incentive Fees and Profit Distribution
In private equity, incentive fees are based on the profits booked from exiting investments, and they may be subject to a hurdle rate. The way profits are allocated between GPs and LPs is called the “partnership’s waterfall.” There are two main systems: the American (deal-by-deal) waterfall and the European (whole-of-fund) waterfall.
EXAMPLE
Consider a fund with a 20% incentive fee and two deals, A and B. Deal A had an invested capital of $3 million and was sold for $4 million, while Deal B had an invested capital of $7 million and was sold for $6.4 million.
American Waterfall: Profits are distributed as each deal is exited. For Deal A, the GP gets $200,000 (20% of the $1 million profit), and the LP receives $3.8 million. For Deal B, there’s a loss, so the GP gets nothing. Overall, the GP gets $200,000 from a total profit of $400,000, or 50% of the total profits.
European Waterfall: Incentive fees are determined based on the aggregate profit for the whole fund, not on a deal-by-deal basis. In this case, 20% of the $400,000 total profit would mean an incentive fee of $80,000 for the GP. To implement this, LPs receive all distributions until they recover 100% of their initial investment, plus any hurdle rate. For this case, the $4 million from Deal A goes to the LPs first. Proceeds from Deal B are then distributed between the LP and GP to ensure the GP gets 20% of the aggregate profit from the fund.
Both arrangements have their drawbacks. In the whole-of-fund waterfall, GPs may not receive incentive fees for a long time, while deal-by-deal waterfalls can lead to GPs receiving more incentive fees than agreed upon, as in our example.
A clawback provision allows LPs to reclaim part of the GP’s incentive fee if they end up receiving more than agreed upon. In our example, LPs under the deal-by-deal waterfall arrangement could reclaim the extra $120,000 fee received by the GP from the first deal.
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