Understanding Private Equity

Private equity is an asset class that includes companies that are not publicly listed on a stock exchange. A private equity investment typically involves the takeover of a company, which is then restructured as a limited partnership. Private equity can be divided into several categories including leveraged buyouts (LBOs), venture capital (VC) and distressed investments. The purpose is to unlock value from the target company that was not previously recognized in the marketplace.

Private equity is typically structured as a partnership with a general partner (GP) and limited partners (LP). The GP is responsible for sourcing, reviewing and executing investment opportunities as well as overseeing daily operations and decision-making of the fund. The GP prepares the legal framework, including the offering memorandum. The LPs are the individuals and institutional investors providing most of the capital. Once the partnership has reached its targeted size, it is closed to new investors and operates with a fixed amount of capital.

Private equity, one of the oldest forms of investing, offers portfolio diversification, tax efficiency and potential for higher absolute returns over time than traditional investments through lower correlation. Private equity also carries different risks than traditional investments.

In the early years, investors typically experience negative cash flows as capital is called for deployment. As time goes by, the cash flows increase and turn positive. This is known as the J-curve effect. As the fund matures, cash is returned to investors through distributions generated from the return on the initial investment. On average, a private equity fund will hold an investment for three to five years prior to exiting. The holding period is dependent on various factors including economic and market conditions.

Investors should be aware of private equity’s long time horizon and lack of short-term liquidity. Traditional private equity partnerships typically last 10 to 15 years. Historically, it was difficult for investors to readily liquidate their private equity investments. However, over the past decade, there has been a growing secondary market for private equity. Secondary markets can provide added liquidity for existing investors. But that liquidity comes at a price as buyers typically purchase private equity interests at discounts to their net asset value or NAV.

dding private equity to a portfolio may enhance overall returns, provide greater diversification, improve tax efficiency and dampen volatility. Private equity ownership takes a more active approach to investing and often includes management or board representation. This structure provides greater influence on the strategic direction of the company as well as better alignment of interests between investors and management. Unlike publicly traded stocks, private equity funds are not priced daily so their price volatility and return correlation may be lower.

Investors in private equity include pension funds, endowments, foundations, high-net-worth individuals and other long-term investors. In the 1980s, institutions were the primary allocators to private equity funds. Today, while institutions still make up the majority of private equity investors, we’re seeing more high-net-worth individuals taking advantage of new structures offering lower minimums. HNW investors have grown more comfortable with illiquid assets as they view illiquidity as a necessary tradeoff for potentially higher returns and added diversification. Private equity investing often carries high investment minimums and, in some cases, may only be available to accredited investors with at least $1 million in assets.

Two widely used methods are internal rate of return, or IRR, and multiple of invested capital, or MOIC. IRR is the discount rate that sets the net present value of a series of cash flows equal to zero. IRR allows investors to measure the performance of a series of irregular cash flows. MOIC is the calculation between capital invested and capital returned. For instance, $1 invested in a private equity fund that returns $5 in distributions implies a 5x multiple return. This feature is beneficial for investors, as capital is called and invested over time, resulting in negative cash flows, while distributions generate positive cash flows for the investor. MOIC is a measure of capital invested versus capital returned without any sensitivity to the timing of cash flows.

* See disclosure for more on limitations of IRR.

An investment in a primary fund without knowing its future investments. The fund will make investments that are in line with the fund’s investment mandate, with limited to no influence by the LPs.

Notices issued to LPs when the GP has identified a new investment and a portion of the LPs’ committed capital is used to finance its operations.

The share of partnership profits received by the GP, with the remainder distributed to investors, regardless of whether the GP contributed any capital. It is essentially a performance-based fee that motivates the general partner.

Once a fund has returned all capital to investors and reached its desired return, the GP begins to collect carried interest dating back to the initial profits returned by the fund. To recoup their share of the proceeds, GPs often include a catch-up provision to retain most of the fund’s profits until it has received its share of the gains.

An opportunity to invest alongside a private investment fund, typically on a discretionary basis.

The money that an investor has agreed to contribute to a fund.

The disbursement of assets from a fund, either in cash or shares.

A method for prioritizing cash flows from a private equity investment among limited partners and the general partner. The waterfall includes a return of capital, preferred return, catch-up and carried interest. The purpose is to align incentives for the general partner and define payments for limited partners.

The direction of cash flows—in the shape of the letter J—through the life cycle of a private equity fund. In the early years, investors provide capital and pay management fees, which leads to negative cash flows. Over time, cash flows turn positive as returns on the initial investment are realized.

The legal structure through which institutions and individuals invest in private equity, generally fixed-life partnerships.

The targeted minimum annual return provided to limited partners before the general partner shares in profits. It ensures the general partner will share in the profits only if the investments meet or exceed the preferred return.

IRS documentation distributed to investors by a partnership, which provides flow-through income, losses and dividends reported on an investor’s individual tax return.