Understanding Private Equity (PE)

PE Definition

• Private Equity (PE) involves professionally managed investments in private companies.
• It is a type of investment where funds buy, restructure, and grow private businesses.
• PE investors often acquire whole businesses or substantial ownership stakes to turnaround or grow them.

Key Characteristics of PE

• PE is a long-term investment , typically lasting 3-7 years.
• It involves hands-on management and strategic involvement.
• PE investments are illiquid and not freely traded in public markets.
• It offers high return potential but comes with higher risk.

PE Scope

• PE assists mature companies facing market disruptions and competition to modernize.
• It helps poorly performing companies identify and fix their problems.
• PE provides external capital and managerial expertise to help businesses overcome challenges and seize opportunities.
• PE steps in with capital, expert advice, and operational support through venture, growth, and buyout funds
• PE equity assists struggling/growing companies by providing capital, expertise, and support, especially when traditional institutions are insufficient.

PE Strategies

• Private Equity (PE) operates across three main investment strategies: Venture Capital (VC), Growth Equity, and Buyouts.
• Venture Capital (VC) is an early-stage investment that focuses on startups and young companies with high growth potential, providing seed funding with high risk but potentially massive returns.
• Growth Equity targets established, revenue-generating companies needing capital to scale operations, where PE firms take minority or majority stakes and accelerate growth through capital, strategic guidance, and operational improvements.
• Buyouts are mature-stage investments that involve acquiring controlling stakes in mature, undervalued, or struggling companies, often using leveraged buyouts (LBOs) with debt, to improve efficiency, restructure operations, and sell at a profit.

PE vs Public Inverstors

PE Firm

• A PE firm is an investment management company that raises capital from investors (LPs) to acquire, manage, and exit private companies for high returns.
• It specializes in venture, growth, or buyout investments.
• A PE firm raises and manages funds through two affiliated legal entities: the General Partner (GP) and the investment manager.
• Key decision-makers at the firm oversee both entities for all funds raised.
• Separate legal structures protect the firm from liabilities and claims related to the fund.
• PE firms structure their operations to manage investments effectively while minimizing liability.

PE Fund

• PE fund is a pooled investment vehicle managed by a PE firm.
• It raises capital from investors (LPs) to invest in private companies.
• The goal is to generate high returns through strategic management, operational improvements, and eventual exits.

PE Fund Key Characteristics

• Fixed Lifespan – A PE fund is typically structured as a 10+2-year limited partnership with investments made early and exits later.
• Capital Commitments – LPs commit capital upfront, which the GP draws down over time for investments.
• Illiquid Investments – Investments are not publicly traded, requiring long-term commitments of 3-7 years per company.
• Active Management – PE funds provide strategic, financial, and operational support to portfolio companies.
• High Return Potential – PE funds aim for higher-than-public-market returns but carry higher risks.
• Fee Structure – Typically follows a "2 and 20" model with 2% management fees and 20% carried interest.
• Exit Strategies – Common exits include IPOs, strategic sales, and secondary buyouts to realize gains.

Types of Liabilities in PE Funds

• Investment Losses can lead creditors to seek recovery from bankrupt portfolio companies, but the PE firm is shielded.
• Legal Claims & Lawsuits against a portfolio company are generally limited to the assets of that specific fund.
• Debt Obligations in leveraged buyouts (LBOs) do not allow lenders to go after the PE firm's other funds or assets if the company defaults.
• Regulatory & Compliance Risks liability typically stays within the fund's legal entity.
• Limited Partner (LP) Commitments & Disputes affect only that LP's interests.

Legal Structures Used for Protection

• Limited Partnerships (LPs) - Investor (LPs) have limited liability while The PE firm (as General Partner) manages the fund,
• Management Companies - The PE firm operates as a separate legal entity from the funds it manages.
• Special Purpose Vehicles (SPVs) – These are used for specific deals to isolate risks further.
• By structuring funds separately, PE firms limit their exposure to financial and legal risks, ensuring that liabilities within one fund do not impact the entire firm.

PE firm VS PE fund

Limited Partners (LPs)

-LPs provide most of the capital in PE funds but are passive investors.

• LPs' liability is limited to their committed capital.
• Common LPs are pension funds, endowments, insurance companies, banks, corporations, family offices, and fund of funds.
• LPs cannot manage the fund or its investments without jeopardizing their limited liability protection.
• Capital is provided when called by the PE fund, and LPs receive returns upon successful exits.
• LPs act as financial backers, providing capital without direct control over fund management.

General Partners (GPs)

• GPs manage the fund and have a legal duty to act in LPs' best interests.
• GPs issue capital calls and make all investment and divestment decisions based on the fund's mandate.
• GPs may delegate tasks to an investment manager but remain fully liable for the fund's debts and obligations.
• GPs invest their own money (typically 1-5% of the fund) to align their interests with LPs.
• GPs manage the fund, make decisions, and bear responsibility, ensuring alignment with LPs by committing their own capital.

GPs vs LPs

The Investment Manager

• The investment manager handles daily operations, including evaluating investments, advising companies, and managing reports.
• They earn a management fee for these services.
• Management fees are typically 1.5-2% of committed capital initially, later based on invested capital, decreasing over time.
• The investment manager runs operations and is compensated through management fees that adjust over time.

Portfolio Company

• A portfolio company is a business that a PE fund has invested in as part of its investment strategy, acquired, managed, and eventually sold.
• Ownership Structure: PE funds acquire a controlling or significant minority stake in the company.
• Active Management: PE firms work with the company's management for operational improvements, growth, and increased profitability.
• Exit Strategy: A portfolio company is held for 3-7 years before being sold through an IPO, merger, or secondary sale.
• A PE fund typically invests in 10-15 companies to form its investment portfolio.
• This includes portfolio companies, investee companies, or target companies during due diligence.
• Success depends on selling these companies at a profit within 3-7 years.
• A PE firm balances fiduciary duties to LPs and engagements with portfolio companies.
• Building a strong reputation helps to attract investors and quality investment opportunities.
• A PE firm's success depends on selecting the right companies, generating profitable exits, and maintaining trust with partners.

Portfolio Company (cont.)

• PE firms succeed by raising funds and achieving target returns through smart investments and exits.
• Most PE funds follow a "10+2" model.
• During the Capital deployment phase (first 4–5 years), the GP invests in companies.
• During the Harvesting phase (remaining years), the GP exits investments to generate returns.
• The extra two years give the GP flexibility to exit investments at the right time.
• A PE firm's success securing and exits strategically within the fund's structured timeline.

Fundraising

• PE firms raise capital through multiple funding rounds.
• A target fund size is set, sometimes with a "hard cap".
• First closing happens once a minimum threshold is met, initial LPs join, and the GP can start investing.
• A fund is named for its "vintage year".
• Fundraising lasts 12–18 months until the fund reaches its target size and holds a final closing.
• The total capital committed by investors is called "committed capital."
• PE fundraising is a structured process categorized by "vintage year", finalized once the target size is met.

Investment Period

• The GP draws down capital over time during the investment period.
• The investment period lasts 4–5 years from first closing, extendable with LP approval.
• After it ends, new investments are not allowed.
• Some LP Agreements (LPAs) allow "capital recycling".
• The investment period frames when a PE fund can actively invest, follow-on investments, and capital recycling.

Investment Period (cont.)

• GPs request capital through "capital calls" when needed for investments, fees, or expenses.
• LPs must fulfill capital calls quickly, usually within 10 business days.
• GPs can charge high interest, sell the stake in the secondaries market, or cut them off from future profits if an LP defaults on a capital call.
• "Contributed capital" is the portion of committed capital that has been drawn and invested.
• "Dry powder" is the uninvested portion of committed capital; that can be used by the industry across funds.
• Calls ensure access when needed.

Holding Period

• Holding periods for portfolio companies last 3 to 7 years after investment.
• Successful companies exit earlier, while underperforming ones stay longer.
• GPs team up with management to enhance value and prepare exits.
• The holding period enables PE firms to improve company performance before selling at a profit.

Divestment Period

• Successful exits measure a GP's performance in PE.
• Exit strategies are planned from the beginning of an investment.
• After exit, profits and capital are distributed to LPs and the GP.
• Exit proceeds cannot be reinvested without specific conditions.
• If a fund still holds investments at its life's end, the GP may extend the fund to avoid a forced sale.
• PE firms must strategically plan and execute exits to maximize returns.

Key Periods in PE

• Investment Period (Capital Deployment Phase) – Lasts for 4-5 years.
  • GPs do not take all the committed capital upfront but gradually call capital.
  • GPs identify, evaluate, and invest in portfolio companies.
  • Lasts for 4-5 years that can be extended if needed.
• Harvesting Phase (Exit & Value Realization) – Is the remainder of the term.
  • GPs improve companies through operational efficiencies, expansion, and governance.
  • GPs sell portfolio companies.
  • Returns are distributed back to LPs.
• Full PE Fund Lifecycle – Follows the "10+2" Model
  • Most PE funds operate on a 10-year term, with an additional option of 2 one-year extentions.

The LP Perspective

• PE historically outperforms public stocks and bonds.
• Illiquidity leads to higher returns but greater risks.
• PE investments require long-term commitment, making allocation difficult.
• LPs must manage liquidity carefully due to long lock-ups and short notice for capital calls.
• PE offers high return potential that has a long-term commitment and careful planning due to illiquidity.

The LP Perspective (cont.)

• Managing cash flows is a major challenge for PE investors.
• New LPs face years of negative cash flows before positive returns.
• Experienced LPs diversify across 100+ funds, creating complex needs.
• The J-curve charts cash flow patterns, where early losses occur before later gains.
• PE requires long-term patience and strategic cash flow management, especially in the early years when returns are negative.

The J-Curve

• It represents investors net cash flow in a PE fund over time.
• Initially, LPs experience negative cash flow due to capital calls and fees.
• Exists return capiral and curve turns upward during the divestperiod.
• Breakeven occurs when the J-curve crosses the x-axis.
• Forecasting capital calls and distribution is difficult which requires management.
• The secondary market imroves liquidity which shortens the j-curve.
• The J-curve highlights a link between investment/returns, patient capital, and planning.

The Fee Structure and Economics of PE

• PE funds follow the "2 and 20" fee structure.
• The 2% is the annual management fee LPs pay.
• The 20% is the carried interest paid to the GP.
• The remaining 80% of profits is given pro rate to LPs.
• Since carried interest is the main incentive, PE professionals focus on maximizing returns.
• The "2 and 20" aligns firms/investors, as GPs are motivated to generate strong fund performance for carry.

The Fee Structure and Economics of PE (cont.)

• PE returns are measured using the IRR and Multiple of Money Invested (MOIC).
• Net return factors show actual profit.
• LPs evaluate using net returns at life's end.
• LPs use most relevant measure, because of reflective true profitability,

Management Fees

• Expenses are provided through fees.
• Traditionally, fees were 2% per year, but now range from 1.3% to 2.5%.
• Smaller or first-time funds charge higher while larger and mezzanine funds tend to have lower fees.
• Since the 2008 financial crisis, have faced pressure, offset by more co-investment opportunities for LPs.
• They vary by fund size and strategy, and LPs now negotiate better terms to reduce costs.

Management Fees (cont.)

• Fees start from first closing and are paid quarterly or semi-annually in advance.
• During investments fees are charged on committed capital; afterward, they use net invested capital.
• Fee revenue declines over a fund's life as investments are made and exits occur.
• Early fees come from investors' capital; later, exits may cover fees.
• Fees shift from committed capital to invested capital/exit proceeds.

Other Fees

• Additional fees may be charged, especially in control buyouts.
• Include transaction fees (investment/exit-related) and monitoring.
• Other fees can cover broken deals.
• Offsets reduce fee burden by deducting a portion of "other" fees from management fees.
• This shift lowers LPs costs.
• Other fees increase costs, but fee offsets have become common.

Carried Interest

• It is the GP's share of profits, generally 20%, serving as their main incentive.
• Distributions follow a "waterfall" structure, using LPA.
• First, capital is returned to LPs with rates.
• Then, a catch-up mechanism that receivies the profits to that point.
• Leftover are split 80% to LPs, 20% to GP.
• Clawback provisions ensure GPs return any excess profits.
• AlignGP success, but waterfalls structures ensure LPs receive their before GPs earn their share.

Carried Interest Distibuting Models

• Two models:

1. European Style: GP receives capital after the LP capial been returned. Needs hurdle rate.
2. American Style: GP recieves carried interest after profitable exit, GP earnings for exits.

• EU favors, while AM allows earlier, but includes protections againts losses.

PE funds VS Traditional Asset Classes

• PE funds differ from traditional assets.
• Illiquidity-PE invesments are not freely, commit to term .
• Unpredictable cash flows-Cash flows are from distributions.

Unpredictable Cash Flows In PE Funds

• Funds has high varibable, like cash, therefore, Unpredicatable due from 4 aspects:

1. Capital Calls- DO not requre the full commited up front. Insstead it called periodcally,
2. Timing Uncertainty- Time of calls are predicatble for investors.
3. Unven cash flows- out low and high in in the early, but flow end.

Unpredictable Cash Flows in PE Funds (cont.1)

2. Distributions Returns from PE is from successful exits. PE disributions are lumps.

Exits is incertain and markets can affect this . Performance distribitions canbe delayed if investements peforms low.

Unpredictable Cash Flows in PE Funds (cont.2)

3. Representation Effect, that LP experince early years of negative and late years of poistive.

• Early years-High costs->Neg
• Mid to Late Years ->Increase to postive from exits.

• to final stage.

Unpredictable Cash Flows in PE Funds (cont.2)

Liquifity is importent.

1. Mangagement of challegs
2. liquidity is key
3. credits lines are uses as well

Funds liquidity management

Alignment of INterest Trhoguhs & Profit Sharing in PE

PE, Fund strucutres and alignement can evolve when meetured.

• Fee, 1.3%-2.6% fees for costs that doesnt encentives performance. Treding- Higher the early, but decline and mature in capial invested.

• Profit Share incentvizes of share funds with a hurdle.

• catch fair with a allcaitin

Alignment of Interest Throught FFees..

• Changes to incentives Period: 4-5 Years is enfficietly used.
• mid to late, years that focuses of maximizes to exits.
• final stage, to help secure the intrests.

funds stracture focus more for deployment