private equity fund diagram

Diagram of the structure of a generic private equity fund

Institutional investors provide private equity capital in the hopes of achieving risk adjusted returns that exceed those possible in the public equity markets and will typically include private equity as part of a broad asset allocation that includes traditional assets (e.g., public equity and bonds). Most institutional investors, do not invest directly in privately held companies, lacking the expertise and resources necessary to structure and monitor the investment. Instead, institutional investors will invest indirectly through a private equity fund. Certain institutional investors have the scale necessary to develop a diversified portfolio of private equity funds themselves, while others will invest through a fund of funds to allow a portfolio more diversified than one a single investor could construct.

Private equity firms generally receive a return on their investments through one of the following avenues:

* an Initial Public Offering (IPO) – shares of the company are offered to the public, typically providing an partial immediate realization to the financial sponsor as well as a public market into which it can later sell additional shares;
* a merger or acquisition – the company is sold for either cash or shares in another company;
* a Recapitalization – cash is distributed to the shareholders (in this case the financial sponsor) and its private equity funds either from cash flow generated by the company or through raising debt or other securities to fund the distribution.

Investment features and considerations

Considerations for investing in private equity funds relative to other forms of investment include:

* Substantial entry requirements. With most private equity funds requiring significant initial commitment (usually upwards of $1,000,000) which can be drawn at the manager’s discretion over the first few years of the fund.

* Limited liquidity. Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as “illiquid” investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to achieve liquidity before the manager realizes the investments in the portfolio as an investor’s capital is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.

* Investment Control. Nearly all investors in private equity are passive and rely on the manager to make investments and generate liquidity from those investments. Typically, governance rights for limited partners in private equity funds are minimal.

* Unfunded Commitments. An investor’s commitment to a private equity fund is drawn over time. If a private equity firm can’t find suitable investment opportunities, it will not draw on an investor’s commitment and an investor may potentially invest less than expected or committed.

* Investment Risks. Given the risks associated with private equity investments, an investor can lose all of its investment. The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development or in companies with high amounts of financial leverage. By their nature, investments in privately held companies tend to be riskier than investments in publicly traded companies.

* High returns. Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.

For the above mentioned reasons, private equity fund investment is for those who can afford to have capital locked in for long periods of time and who are able to risk losing significant amounts of money. These disadvantages are offset by the potential benefits of annual returns which range up to 30% for successful funds.