The following is adapted from The Private Equity Playbook
Defining the Private Equity Fund
Let’s start with the concept of a mutual fund. A mutual fund aggregates money from a variety of investors and pools that money together. A fund manager decides what stocks to buy with the money. The funds have readily available liquidity and are publicly traded. If you want to buy a typical mutual fund, you hop onto your Fidelity account (or wherever you invest) and purchase a piece of it. That money is then aggregated with everyone else who has contributed. You can hold that investment as long as you want—for one day or five years—but you have no say over the trades made by the fund manager.
I liken a private equity fund to a mutual fund. A private equity fund, by its very nature and name, is private. It aggregates capital from a number of sources: primarily pension funds, wealthy families, individuals, and companies that have meaningful assets available for investment. Depending on the size of the fund, it is typical for an established firm to have a minimum investment size of $5 million. These funds are then used to purchase companies or buy a stake in a company. Employees of the private equity firm may also invest alongside the fund through the use of a sub fund, to demonstrate to investors that they’ve got skin in the game as well.
People who invest in a private equity fund are called limited partners. Limited partners have no decision-making authority over the private equity firm, or the investments made by the fund. The private equity firm serves as the general partner and has total control over the funds’ investments. Limited partners pledge capital for a specified amount of time, generally the life of the fund, and thus cannot buy and sell on a whim. There generally is no liquidity and a private equity fund typically has a charter, or a lifespan, of ten years. This means you’re committing capital for a period of up to ten years. (Note: it’s typical for funds to have built in, up to two, one-year extensions that don’t require further approval of limited partners, so the money could actually be locked up for as long as twelve years.)
Private Equity Means No Liquidity
The private equity fund is made up of people committed to providing capital. They’ve signed up for it. They may not get their money back for ten years or more. The firm makes investments and issues capital calls to the limited partners. As a limited partner, you send in your portion to meet the demand for the cash that’s needed at the time. Because it’s private, there’s no liquidity, and a limited partner has no decision power. There’s no way to get your capital back on demand. This is typically why investment sizes are large. Private equity firms are not geared to handle non-accredited investors who may need to get their money out quickly. The return of capital also happens over time. Any time a private equity fund sells a company or refinances for the purpose of creating a distribution, it returns capital to its limited partners. In the early years of a fund’s existence money is mostly flowing into it from limited partners as the private equity firm is buying companies it intends to grow, and in the later years the flow of money is mostly returning to limited partners as companies are sold. This all happens over a 10 to 12-year period.
Private Equity Evolution
According to Preqin, in their 2018 Global Private Equity and Venture Capital Report, private equity funds have grown from 312 firms in 1990 to 5,391 firms by the end of 2017. Assets under management, since the year 2000, increased from about $500 billion to $2.83 trillion by the end of 2017. During the 1980s, less than 1 percent of merger and acquisition activity involved private equity. Today, it is estimated by EisnerAmper, in their 4Q 2018 PE Insights Report, that approximately 35% of all mergers and acquisitions completed in the USA in 2018 involved private equity and that within 5 years, that number could eclipse the 50% mark.
Private equity funds typically beat most benchmark indices. They’re a popular investment vehicle, especially for pension funds and wealthy investors who are looking for alternative investments and higher returns.
For more information on private equity firms and funds, you can find The Private Equity Playbook on Amazon.