deployed through core PE strategies. This capital is being invested and managed by over 8,000 professional funds globally. Understanding this industry – its drivers and its dynamics – is a must for entrepreneurs, owners of family businesses, board members of multinationals and senior managers.
So what exactly is PE? PE funds invest long-term capital in private (or, at times, public) companies in return for an equity stake that is not freely tradable on a public market.4 Our definition of PE includes so-called “take-privates” (i.e., delistings of public companies) and private investment in public equity that come with specific governance rights. This book focuses strictly on the activity of professionally managed PE funds advised by highly specialized intermediaries (PE firms) and excludes “informal” private capital, such as investments made by business angels or families who typically draw on their own private wealth.
This first chapter gives our readers a high-level overview of PE funds, by defining their structure and the motivation of the key players involved. We then explain how PE funds go about their business, both from the general partner’s (GP’s) and limited partner’s (LP’s) perspective and shed light on the often complex economics and fee structures in PE.
PRIVATE EQUITY FUNDS DEFINED
A PE fund is a stand-alone investment vehicle managed by a PE firm on behalf of a group of investors. The capital is raised with a clear mandate to acquire equity stakes in private companies and divest them over time.
Most PE funds globally are set up as closed-end limited partnerships and operate as “blind pool” vehicles. Closed-end funds have a finite lifespan and require investors to commit capital for the fund’s entire term – typically 10 years – without early redemption (or withdrawal) rights.5 While investors in a PE fund have a clear idea of its broad mandate (for example, mid-market European buyouts), they have no say in the choice of the individual companies that a fund will invest in, hence the term “blind pool.” Certain jurisdictions use limited liability companies or corporate structures as the vehicle of choice for a PE fund, but they are the exception.
We will start with a closer look at the parties involved in a limited partnership PE fund structure, as shown in Exhibit 1.1.
Exhibit 1.1 Limited Partnership PE Fund Structure
PE FIRM: A PE firm is a company with expertise in executing a venture, growth or buyout investment strategy. It raises and advises a fund – and, if successful, over time a family of funds – generally through two separate yet affiliated legal entities: the GP and the investment manager. Members of a PE firm typically hold all the key directorships and other decision-making positions of both the GP and the investment manager for every fund raised by the firm. Establishing these separate legal entities insulates the PE firm from liabilities related to and its principals from any claims on the PE fund. Examples of notable PE firms are buyout firms Kohlberg Kravis Roberts (KKR) and APAX Partners as well as venture firms Sequoia Capital and Kleiner Perkins Caufield Byers.
LIMITED PARTNERS: Investors or LPs contribute by far the largest share of capital to any PE fund raised. LPs participate merely as passive investors, with an individual LP’s liability limited to the capital committed to the fund. Investors active in PE include private and public pension funds, endowments, insurance companies, banks, corporations, family offices, and fund of funds.6 LPs are purely financial investors and cannot be involved in the day-to-day operation or management of the fund or its investee companies without running the risk of forfeiting their limited liability rights. LPs legally commit to provide capital for investment when it is drawn down (or “called”) by the PE fund and they receive distributions of capital – including a share of profits – upon successful exit of the fund’s investments.
GENERAL PARTNER: A fund’s GP is wholly responsible for all aspects related to managing the fund and has a fiduciary duty to act solely in the interest of the fund’s investors. It will issue capital calls to LPs and make all investment and divestment decisions for the fund in line with the mandate set out in its Limited Partnership Agreement (LPA). The GP may delegate some of the management functions to the investment manager or a PE firm’s investment committee (IC),7 but remains fully and personally liable for all debts and liabilities of the fund and is contractually obligated to invest the fund’s capital in line with its mandate.8 A GP – and in turn a PE firm’s partners and senior professionals – will also commit capital to the fund to align its interest with that of the fund’s LPs by ensuring that the firm’s partners have “skin in the game”; the GP stake typically ranges from 1 to 5 % and rarely exceeds 10 % of a fund’s total capital raised.
INVESTMENT MANAGER: In practice, the investment manager9 conducts the day-to-day activities of a PE fund; it evaluates potential investment opportunities, provides advisory services to the fund’s portfolio companies, and manages the fund’s audit and reporting processes. The manager is paid a management fee by the fund for providing these services, some of which may be passed on to a subadvisor. The management fee is typically set at around 1.5−2 % of committed capital during the investment period of the fund; after the end of the investment period, it is calculated on invested capital and may step down to a lower rate. More information on fee structures can be found later in this chapter.
PORTFOLIO COMPANY: Over its lifecycle, a PE fund will invest in a limited number of companies, 10−15 on average, which represent its investment portfolio. These companies are also referred to as investee companies or (during the due diligence process) as target companies. A PE firm’s ability to sell its stakes in these companies at a profit after a three- to seven-year holding period will determine the success or failure of the fund.
From the perspective of the PE firm and its affiliated entities, the business of PE comes down to two simple yet distinct relationships: on the one hand, the firm’s fiduciary duty towards its LPs and on the other hand its engagement with entrepreneurs, business owners and management teams in its portfolio companies (Exhibit 1.2). Establishing a reputation of professional conduct and value-add will ensure access to both future fundraising and investment opportunities.
Exhibit 1.2 Key Relationships GPs Must Manage
THE GP PERSPECTIVE
LIFECYCLE OF A PE FUND
A traditional PE firm’s business model relies on success in both raising funds and meeting its target return by effectively deploying and harvesting fund capital. PE funds structured as limited partnerships are typically raised for a 10-year term plus two one-year extensions, commonly referred to as the “10+2” model. Generally speaking, a GP will deploy capital during the first four to five years of a fund’s life and harvest capital during the remaining years. The two optional years allow the GP to extend a fund’s lifespan at its discretion if and when additional time is needed to prudently exit all investments.
Exhibit 1.3 shows the overlapping timelines for the fundraising, investment, holding, and divestment periods of a closed-end fund.
Exhibit 1.3 Lifecycle of a PE Fund
In our context, PE takes on a broad definition that includes VC, growth capital, and buyout funds. It should be mentioned that other sources might restrict the definition of PE to buyout activities and consider VC to be a separate asset class. Further, PE is frequently defined as investments in private companies but buyout activities extend to investments in and the privatization of public companies. For the sake of clarity, our definition of “private” equity refers to the status of the equity stake held by the PE fund post-investment.
The PE secondaries market can provide liquidity for an LP wishing to sell its interest in a PE fund. This market has developed rapidly over the last decade with dedicated funds raised for the express purpose of acquiring secondary fund stakes. See Chapter 24 Private Equity Secondaries for more information.
The IC is typically a committee of the GP and makes the binding investment and divestment decisions for the fund under delegated authority from the GP (“binding” in the sense that once the IC votes, there is no other vote needed or taken).
GPs are usually set up as distinct special purpose vehicles (SPVs) for each fund; these SPVs serve as the GP for only one fund to avoid cross-liabilities between related funds of the PE firm. Please refer to Chapter 16 for further details on fund formation.
Investment managers will also be referred to as advisors or simply managers.
