Private Equity: Basics and what to expect?

What is private equity fund and how it works:Assume you come across a great real estate deal where one of your friends is selling a large tract of his farmland for a discount as he is moving out of the country. The value of the land is high, and you cannot pay for it yourself. What would you do? Well, you ask your dad and one of your friends to chip in and share profit (later when you sell the land) based on the percentage of the price paid. This is one of the common forms of private equity that we may encounter in our daily life.

A private equity fund pools capital from multiple investors to invest in unlisted companies. These funds aim to acquire a significant stake in these companies, often with the goal of improving their performance and increasing their value over time. Private equity funds typically follow a cycle:

• Fundraising: The fund managers raise capital from various sources, such as institutional investors, high-net-worth individuals, and pension funds.

• Investment: The fund identifies promising companies to invest in, often focusing on those with growth potential or in need of restructuring. They acquire a significant ownership stake in these companies.

• Value Creation: Private equity firms work closely with the management of the invested companies to make operational improvements, strategic changes, or financial adjustments that aim to increase the company's profitability and overall value.

• Exit: After a period of holding and improving the companies (typically 3 to 7 years), the private equity fund aims to "exit" its investments. This can be done through various means, such as selling the company to another firm, taking it public through an initial public offering (IPO), or conducting a merger.

• Distribution: Once an exit occurs and profits are realized, the fund distributes the returns to its investors, which can include both the initial investment amount and a share of the profits generated during the holding period.

Private Equity Returns:

Private equity funds tend to target higher returns compared to traditional investments like stocks or bonds. However, they also carry higher risks due to the active involvement in managing companies and the longer investment horizon. It's important to note that investing in private equity funds usually requires a significant amount of capital and is typically suited for institutional investors or high-net-worth individuals.

Parties involved and working of Limited Partner Agreement (LPA) PE funds.

Private equity (PE) refers to a form of investment where funds are raised from various investors to acquire ownership or control of private companies. These investments are not traded on public exchanges. Private equity firms typically use these funds to invest in companies, restructure them, improve their operations, and eventually sell them for a profit. A private equity transaction, usually involves three main parties:

Limited Partners (LPs): These are the investors who contribute capital to the private equity fund. LPs may include institutional investors such as large funds, endowments, and other wealthy individuals. They are "limited" in their liability to the amount of their investment, meaning their liability is limited to the amount of funds invested. The personal assets of the LPs cannot be used to recoup losses in PE investments.

General Partners (General Partners): General Partners actively manage the private equity fund and are responsible for making investment decisions, managing the portfolio companies, with an aim to generate returns for the investors. General Partners also contribute their own capital to the fund and receive a management fee and a share of the profits (carried interest) as compensation.

Portfolio Companies: The target private businesses in which the private equity fund invests are called portfolio companies. The General Partners work to enhance the value of these companies through operational improvements, strategic changes, and other means.

What is Limited Partnership Agreement (LPA) and how it works?

For most business deals, you need to enter into a contract that specifies the amount of money put in, the share in the profits, roles and responsibilities, and other characteristics. This contract for a Private Equity investment is called the Limited Partnership Agreement (LPA). LPA outlines the terms and conditions, and the rights, responsibilities, and obligations of both the limited partners and the general partners. The LPA covers various aspects, including:

• Capital Contributions: Specifies how much each limited partner needs to contribute to the fund and the timeline for these contributions.

• Profit Sharing: Outlines how profits are distributed between limited partners and general partners. Carried interest, the share of profits earned by General Partners, is typically subject to a hurdle rate or preferred return before General Partners can receive a larger share.

• Management Fees: Describes the fees paid by limited partners to cover the costs of managing the fund. This fee is typically a percentage of the committed capital.

• Investment Strategy: Details the types of investments the fund will make, industry focus, and geographic preferences.

• Fund Duration: Specifies the expected lifespan of the fund and when investments are expected to be realized.

• Governance and Decision-Making: Explains how investment decisions are made, how often investors receive updates, and the level of involvement LPs have in the fund's operations.

• Exit Strategies: Outlines the planned methods for exiting or selling investments and returning capital to limited partners.

Overall, the LPA serves as a legally binding agreement that protects the interests of both limited partners and general partners and provides a framework for the fund's operations and performance.

Key terms used in LPA about General Partner and LP in private equity fund:

Private equity is vast and includes innumerable features. The terms can be confusing for a finance beginner. Therefore, we have tried listing most common terms in context of Limited Partner Agreements (LPA) for private equity funds, related to General Partners (General Partners) and Limited Partners (LPs):

• General Partner (General Partner): The managing entity responsible for making investment decisions, managing the fund's operations, and executing the investment strategy.

• Limited Partner (LP): The investor who commits capital to the private equity fund but has limited liability and involvement in fund decisions.

• Capital Commitment: The amount of money an LP agrees to contribute to the fund over a specified period.

• Management Fee: An ongoing fee paid by LPs to the General Partner to cover the costs of managing the fund.

• Carried Interest (Carry): The share of profits earned by the General Partner on successful investments, typically calculated as a percentage after a certain level of returns is achieved for LPs.Hurdle Rate: It is the minimum percentage return that the General Partners need to achieve to become eligible for receiving carried interest.

• Clawback: A provision that allows LPs to reclaim excess carried interest paid to the General Partner if the fund's performance does not meet certain benchmarks.

• Distribution Waterfall: The order in which profits are distributed to the General Partner and LPs after achieving the hurdle rate, often structured in tiers or levels.

• Preferred Return: A minimum rate of return that LPs receive on their invested capital before the General Partner is entitled to carried interest.

• Commitment Period: The timeframe during which LPs are expected to fulfill their capital commitments to the fund.

• Investment Period: The period during which the General Partner is actively investing the capital raised by the fund into various investments.

• Key Person Clause: A provision that outlines the key individuals responsible for managing the fund and the potential consequences if they leave or become incapacitated.

• Co-Investment: Opportunities for LPs to invest directly alongside the fund in specific deals.

• Distributions: Payments made to LPs from the fund's profits when investments are realized.

• Governing Law: The jurisdiction's legal framework dictates how disputes and legal matters related to the LPA will be handled.

These terms help outline the roles, responsibilities, and financial arrangements between General Partners and LPs within the framework of a private equity fund. It's important for both parties to understand and negotiate these terms before entering an LPA.

Private equity investment strategies:

Private equity firms employ various investment strategies to generate returns for their investors. Some common private equity investment strategies include:

• Buyouts: Acquiring a controlling stake in an existing company, often with the intention of improving its operations, increasing efficiency, and eventually selling it at a higher valuation.

• Venture Capital: Investing in early-stage startups with high growth potential. Venture capital firms provide funding and support to help these startups develop and succeed.

• Growth Capital: Investing in more established companies that are seeking funds to expand their operations, enter new markets, or launch new products.

What is commingled fund, separate entity, fund of funds and co-investing in private equity?

Here's a brief explanation of each of those terms:

Commingled Fund: A commingled fund is a pooled investment fund where multiple investors combine their capital to invest in various assets, such as stocks, bonds, or real estate. These funds are managed by professional asset managers and provide diversification and economies of scale to the investors.

Separate Entity: A separate entity refers to a legal and financial structure that is distinct and separate from its owners or other entities. In the context of investments, it often refers to setting up a distinct legal entity to hold and manage specific assets or investments, which can provide certain benefits such as liability protection or specific tax treatment.

Fund of Funds: A fund of funds (FoF) is an investment strategy where one investment fund invests in other funds rather than directly in individual securities or assets. It allows investors to access a diversified portfolio of underlying funds managed by different managers or focusing on various strategies.

Co-Investing in Private Equity: Co-investing in private equity involves multiple investors collaborating to invest collectively in a single private equity opportunity. This approach allows investors to pool their resources to participate in larger deals that might be more challenging to access individually. Co-investors often work alongside a private equity firm to make these investments.