Private Equity

A private equity fund refers to securities in companies that are not listed on a public stock exchange. In other words, the concept refers to any type of equity investment in an asset that is not easily tradeable on a public stock market. The private equity market is estimated (by some) to be worth in excess of US$900 billion worldwide.

The private equity industry is a niche segment within the broader capital market.  Each private equity fund/firm has committed capital that is required to be invested into privately held companies for a financial return that is anticipated to be superior to the return available in the public markets.

Structure

Generally, private equity funds are organised as limited partnerships, which are controlled by the private equity firm that acts as the general partner.

The fund obtains 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.

It should be pointed out that the general partner receives management fees for looking out for suitable investments. The management fee is typically a percentage of the funds total equity capital. Furthermore, the general partner might also be entitled to a performance fee based on the profits the fund producers. For example, the general partners would receive management fees of 2% of capital and 20% of profits above a certain level, usually referred to as the 'hurdle level'.

Buying

The sale of private securities are used by companies to generate capital. 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.

There are substantial entry costs associated with investing in private equity firms, usually in excess of hundreds of thousands of dollars. Furthermore, you may be required to keep investing for the first few years of the fund, this is referred to as 'drawdown'. It's a long term investment; generally more than 10 years.

Basically private equity investment is for those who can afford to have their capital locked away 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.

Selling

As mentioned above, private equity firms are not listed on an exchange, therefore an investor wishing to sell securities in private companies must find a buyer without the use of a traditional marketplace such as a stock exchange. Furthermore, there can be many transfer restrictions on private securities.

Operation

All investment decisions are made by the general partner. The general partner would attempt to increase returns through a leveraged buyout (also called 'bootstrap transaction').
A leveraged buyout is a highly leveraged transaction that occurs when a financial sponsor gains a majority control of a target company through the use of borrowed money. The assets of the private equity fund along with the assets of the target company would be used as collateral for the loan required to takeover the company. Such a transaction producers a large return on equity due to the larger risk associated with it.
Another type of investment private equity funds invest in is venture capital. Venture capital is considered highly risky because the money is invested in a business that is either new, struggling or a growing business. It is for this reason and leveraged buyouts that investing in private equity firms can be extremely risky.

Investors generally receive their return through one of three ways:

• an initial public offering
• a sale or merger
• a recapitalisation