PE firms raise capital for a fund by securing capital commitments from investors (LPs) through a series of fund closings.10 A PE firm will establish a target fund size from the outset – at times defining a “hard cap” to limit the total amount raised in case of excess investor demand. Once an initial threshold of capital commitments has been reached, the fund’s GP will hold a first closing, at which time an initial group of LPs will subscribe to the fund and the GP can start to deploy capital. A fund holding its first closing in 2016 is referred to as a “vintage 2016 fund,” a fund with a first closing in 2017 will be known as a “vintage 2017 fund,” and so on. Fundraising will typically continue for a defined period – 12 to 18 months – from the date of the first closing until the fund reaches its target fund size and a “final closing” is held. The total amount raised by a PE firm is known as a fund’s committed capital.
INVESTMENT PERIOD: Rather than receiving the committed capital on day one, a GP draws down LP commitments over the course of a fund’s investment period. The length of the investment period is defined in a fund’s governing documents and typically lasts four to five years from the date of its first closing; a GP may at times extend the investment period by a year or two, with approval from its LPs. Once the investment period expires, the fund can no longer invest in new companies; however, follow-on investments in existing portfolio companies or add-on acquisitions are permitted throughout the holding period. A fund’s LPA may also permit its GP to finance new investments from a portion of fund realizations within a certain limited period after divestment (this is known as the recycling of capital), thus increasing a fund’s total investable capital.
GPs draw down investor capital by making “capital calls” to fund suitable investment opportunities or to pay fund fees and expenses. LPs must meet capital calls within a short period, typically 10 business days. If an LP fails to meet a capital call, various remedies are available to the GP. These include the right to charge high interest rates on late payments, the right to force a sale of the defaulting LP’s interest on the secondaries11 market and the right to continue to charge losses and expenses to the defaulting LP while cutting off their interest in future fund profits. The portion of LPs’ committed capital that has been called and invested is referred to as contributed capital. A fund’s uninvested committed capital is referred to as its “dry powder”; by extension, the total amount of uninvested committed capital across the industry is referred to as the industry’s “dry powder.” Exhibit 1.4 shows the increase of the industry’s dry powder since 2000; the 2015 data adds perspective on its origin by grouping dry powder according to vintage year.12
Exhibit 1.4 PE Industry Dry Powder
Source: Preqin
HOLDING PERIOD: Holding periods for individual portfolio companies typically range from three to seven years following investment, but may be significantly shorter in the case of successful companies or longer in the case of under-performing firms. During this time, a fund’s GP works closely with portfolio companies’ management teams to create value and prepare the company for exit.13
DIVESTMENT PERIOD: A key measure of success in PE is a GP’s ability to exit its investments profitably and within a fund’s term; as a result, exit strategies form an important part of the investment rationale from the start.14 Following a full or partial exit, invested capital and profits are distributed to a fund’s LPs and its GP. With the exception of a few well-defined reinvestment provisions,15 proceeds from exits are not available for reinvestment. When a fund remains invested in a company at the end of a fund’s life, the GP has the option to extend the fund’s term by one or two years to avoid a forced liquidation.16
Box 1.1
RAISING A SUCCESSOR FUND
Established PE firms will raise successor funds every three to four years and ask existing LPs to “re-up” – or reinvest – in their new vehicle. PE firms will typically begin raising a successor fund as soon as permitted by the LPA, usually once 75 % of the current fund’s capital is invested or has been reserved for fees and future deals.
PE firms see their business as a going concern, meaning they continuously work on a deal pipeline of potential investee companies, make investments and divestments. To efficiently capitalize on opportunities in the market, it is crucial for PE firms to have access to capital, ready to be drawn down and deployed, at all times. This also allows a firm to maintain stable operations, employ an investment team and maximize the efficiency of its resources.
Exhibit 1.5 shows the lifecycle of a successful PE firm with a family of four funds.
Exhibit 1.5 Lifecycle of a Successful PE Firm
THE LP PERSPECTIVE
COMMITTING CAPITAL AND EARNING RETURNS
Investors have traditionally allocated capital to PE due to its historical outperformance of more traditional asset classes such as public equity and fixed income.17 However, this outperformance comes with higher (or rather different) risks first and foremost due to the illiquid nature of PE investments. Given its lack of liquidity and the long investment horizon of a PE fund, hitting a target allocation to PE is a far more challenging task than maintaining a stable allocation to any of the liquid asset classes.18 In addition, PE funds’ multiyear lock-up and 10-day notice period for capital calls introduce complex liquidity management questions.
Effectively managing portfolio cash flows is among the key challenges faced by investors in the PE asset class. LPs starting a PE investment program from scratch must prepare for years of negative cumulative cash flows before a positive net return will eventually be generated by their PE portfolios. Seasoned investors with a well-diversified exposure to PE, on the other hand, will often have commitments to well over 100 funds and a complex set of cash flows to manage. A PE fund’s “J-curve” provides a way to visualize the expected cash flow characteristics of an LP’s stake in an individual PE fund and the challenges related to managing a PE portfolio.
THE J-CURVE
A PE J-curve represents an LP’s cumulative net cash flow position – the total capital invested along with fees paid to the PE firm minus the capital returned to the LP by the GP – in a single fund over time. Exhibit 1.6 illustrates the characteristic cash flow for an LP (with a US$10 million commitment to a $100 million fund) over the fund’s 10-year life. For simplicity’s sake we assume both consistent drawdowns from the GP and exits split evenly across the years. It should be noted that capital calls and distributions are difficult to forecast with any degree of accuracy, requiring LPs to develop a flexible approach to cash management.19
Exhibit 1.6 PE Fund Cash Flow J-curve
Please refer to Chapter 17 for more details on the fundraising process and its dynamics.
Please refer to Chapter 24 Private Equity Secondaries for further details on the mechanics behind the transfer of such LP stakes.
Please refer to Chapter 15 for a detailed description of exit considerations and the related processes.
The capital invested in a deal and returned without any profits achieved, may be reinvested under the following conditions: (a) a so-called “quick flip” where an exit was achieved within 13–18 months of investing during the investment period; or (b) to match the amount of capital drawn down to pay fees, with the target to put 100 % of the fund’s committed capital to work. These rules are defined in a “remaining dry powder” test.
Please refer to Chapter 20 Winding Down a Fund for additional information on end-of-fund life options.
Our Chapter 18 LP Portfolio Management takes a closer look at the challenges of deploying assets under management into PE and VC; Chapter 23 Risk Management complements the discussion.
