Where do PE funds get their money?
Private equity funds are generally backed by investments from large institutional investors: pension funds, sovereign wealth funds, endowments and very wealthy individuals. Private equity firms manage these funds, using both investors' contributions and borrowed money.
A source of investment capital, private equity comes from firms that buy stakes in private companies or take control of public companies with plans to take them private and delist them from stock exchanges.
Private equity firms make money through carried interest, management fees, and dividend recaps. Carried interest: This is the profit paid to a fund's general partners (GPs).
Part of the returns for investors in private equity is through receiving dividends, much like shareholders of a public company do. This process is known as dividend recapitalization and involves the process of raising debt to pay private equity shareholders a dividend.
Traditional Deal Sourcing Strategies for Private Equity
On the surface, it's a relatively straightforward process by which firms: Seek out investment banking deals occurring within the market. Discover who is doing the selling. Offer a competitive bid for the deal or formulate their own arrangement.
Private equity firms raise funds by getting capital commitments from external financial institutions (LPs). They also put up some of the their own capital to contribute into the fund (commonly 1-5% but it can be higher).
Private funds raise capital from investors through exempt offerings, which means the offering must fall within an exemption from registration under the Securities Act of 1933.
With so little of their own money at risk, these firms make outsized bets that pay off in good times. In bad times, they make money on the steep management fees paid by investors and monitoring fees paid by portfolio companies. Like the house in a casino, PE firms never lose.
The LPA also outlines an important life cycle metric known as the “Duration of the Fund.” PE funds traditionally have a finite length of 10 years, consisting of five different stages: The organization and formation.
Private equity is a core pillar of BlackRock's alternatives platform. BlackRock's Private Equity teams manage USD$41.9 billion in capital commitments across direct, primary, secondary and co-investments.
Is private equity oversaturated?
Another major downside is that private equity is a much more saturated market today than in previous decades. There's too much capital chasing too few high-quality companies, which means that returns will almost certainly decrease in the future.
Heidrick & Struggle's data suggests that at the top end, a managing partner in a private equity firm with at least $1bn in Assets Under Management (AUM), can expect to earn at least $3.5m in salaries and bonuses, plus around $35m in carried interest over a fund's lifecycle (typically around five years).
When a private equity firm recapitalizes a company, they often use debt financing to finance part of the acquisition price – we have written about this here. In addition, private equity firms often ask owners of the companies they buy to “roll over” or reinvest part of their equity into the new company going forward.
Private equity firms raise most of their capital from what are known as institutional investors. These include pension funds, sovereign wealth funds and insurance companies, among others. (Some PE firms additionally raised money from individuals, typically high-net-worth investors.)
Further, going public enables firms to pay their employees in stock, which, depending on the company's performance, may prove very valuable. Finally, a PE firm's presence on the public market enhances brand visibility which comes with the benefit of attracting new investors, business partners and clients.
Private equity firms thoroughly analyze the investment opportunity and research the business to understand the company’s market position, industry trends, financials, etc. Factors that help them determine if a company is a good investment target or not include: Operation in a non-cyclical industry.
Most private equity money comes from institutional investors, such as pension funds, sovereign wealth funds, endowments, and insurance companies, although many family offices and high-net-worth individuals also invest directly or through fund-of-funds intermediaries.
Berkshire was founded in the mid-1980s, and our first two decades focused solely on investing from our private equity funds. Our team was united around the goals of producing excellent returns for our investors and helping our portfolio companies achieve their potentials.
Private equity fund structure
The fund is managed by a private equity firm that serves as the 'General Partner' of the fund. By contributing capital, investors become 'Limited Partners' of the fund. As such, the fund is structured as a 'Limited Partnership'.
There are three key types of private equity strategies: venture capital, growth equity, and buyouts.
How long do private equity firms keep companies?
Private equity investments are traditionally long-term investments with typical holding periods ranging between three and five years. Within this defined time period, the fund manager focuses on increasing the value of the portfolio company in order to sell it at a profit and distribute the proceeds to investors.
Key Takeaways
The minimum investment in private equity funds is typically $25 million, although it sometimes can be as low as $250,000.
Private equity funds are illiquid and are risky because of their high use of debt; furthermore, once investors have turned their money over to the fund, they have no say in how it's managed. In compensation for these terms, investors should expect a high rate of return.
Disadvantages. Illiquidity: PE investments are typically illiquid, meaning that they cannot be easily bought or sold. This can make it difficult to exit an investment if you need to do so. High Fees: PE investments typically have high fees, which can eat into the returns.
The private equity owned company will have the same basic benefits of healthcare, life insurance, 401(k) and disability benefits as the public company, but often will not have all of the ancillary benefit programs. The larger the private equity owned company, the more likely they will have public company type benefits.
