Private Equity

Types of Private Equity

2012-03-06T07:22:00.000+05:30

There are two major types of private equity:

Venture Capital
Buyouts

In US, "private equity" is generally used to refer the buyout and buy-in investment sector and "venture capital" refers to an initial early stage investment. In Europe, "venture capital" refers to investments at all stages. In modern days, across the globe, the term "private equity" has become common for all stages.

Venture Capitalists specialize in providing finance to high risk operations. They look out for early stage companies, generally in the technology or life sciences businesses. The capital investment is provided in exchange to an equity stake in the business. This gives an opportunity to these small and growing companies to move on to the next stage of development avoiding to borrow from a bank or lender, which can lead to higher interest payments.

Types of Venture Capitalists:

Traditional wealthy families: Rich families in the US sometimes supply venture capital for many years.

Limited partnerships and closely-held corporations: There companies often raise capital from institutional investors, such as insurance companies or pension funds.

Investment and commercial banks.

Wealthy individuals: A network of wealthy individuals is capable of tolerating high-risk investments and depend on each other for advice.

Buyouts are generally appear more attractive for more capital. Buyouts concentrate on a later-stage financing in a company's growth life cycle. Revenues generated by the business can be used to pay down the debt, assuming these borrowings were used as a part of the acquisition process.

Various stages of a typical buyout process:

Identify an ailing or undervalued company
Buy a controlling stake
Take the company private (if necessary)
Improve company's prospects

Generally, in a buyout, all or most of the management team is retained as the team knows the business well and is aware of the risks. The rewards in this are high.

Leveraged Buyouts (LBOs)

Buyouts can be financed by debt and by equity. Equity funding itself is enough for small venture capital investing, though large deals are generally financed by debt as well as equity. These deals are referred to as leveraged buyouts (LBOs).

The deals leverage is determined by ratio of debt to equity. the leverage is determined by the company's ability to service the debt with its on cash flows. The equity portion is provided by the private equity firm or investors, while the debt portion could be in form of bank loans or bond issue.

How is Private Equity Different from a Loan?

2012-03-04T03:47:00.002+05:30

Private Equity companies provide medium or long term financing to companies. It provides long term capital to support unlisted companies grow and succeed. Hence it fills the equity gap, i.e. the missing public capital as the companies have been supported by private capital.

How is Private Equity different from a loan?

Raising private equity capital is different from raising a loan from a bank or lender. Banks have a legal right to interest on a loan and repayment of capital, which can be secured against some assets. Hence, banks gets its returns for sure irrespective of the success or failure of the business.

Private equity is not secured against any assets, but is an investment in exchange for a stake in the company. As shareholders, the private equity company's returns are dependent on the success and profitability of the business. It offers high risk and high returns as compared to the fixed returns earned by banks in a loan.

Hedge Fund

2011-12-31T03:51:00.003+05:30

What is the difference between a private equity fund and a hedge fund?

A Private Equity Fund and a Hedge Fund might sound similar to people who are not too familiar with the alternative investment industry. There is a huge difference in the way in which investment is made in these industries.

Private Equity fund includes privately managed pools of capital that is invested in companies, most of which are not listed on the stock exchange yet. There might be a few commonalities in the structure of a private equity fund and a hedge fund, but the major difference is in their investment strategies. Private equity funds ideally invest for a longer term in private companies and anticipate capital appreciation based on the growth and sustainability of the companies that they have invested in. It can also involve merger and acquisition of companies. Private equity definitely is a higher risk investment as compared to stocks or bonds, but also the returns expected are a lot higher. Investors and fund managers in private equity funds should understand the high risk high return principle. Private equity fund managers might offer their advice to a growing or start up company to help it grow towards a suitable position for an IPO (initial public offering).

For Hedge Funds, there is a no defined pattern and area of investment. It is an unorganized investment and is also not allowed in some countries as it is hard to monitor. A hedge fund generally invests in stock markets (short term), real estate, bonds, other funds and privately owned companies. It is a lot more riskier than Private Equity funds, but the returns can be higher when compared (higher risk higher return). The privately managed investment pools in a hedge fund are not subject to Securities and Exchange Commission (SEC) examinations.

What is Venture Capital?

2011-12-17T07:59:00.003+05:30

Venture capital is a subset of private equity. It involves equity investments, ideally in comparatively newer companies (as compared to typical private equity investments) which are just launched or planning a start up or for expansion of a business. Venture Capital funds invest in young companies often developing a new product or technology.

Venture capital is majorly categorized by the progress of development of the company ranging from early stage capital investment used for the initiation of the start up companies to late stage and growth capital investment that is used to fund growth of business that is generating profit but might not yet be profitable or generating enough capital to fund future growth.

Entrepreneurs often come up with ideas and products that require substantial amount of capital in the start up stage or for the first few years. Many entrepreneurs do not have enough capital to finance the business by themselves, and they must therefore seek outside financing. The venture capitalist's need to generate high profits to compensate for the risk these investment which makes venture funding an expensive capital source for companies. Venture capital is most appropriate for businesses with large capital requirements which cannot be financed by cheaper alternatives such as debt.

Exceptions that might occur

2011-11-12T13:57:00.000+05:30

There can be various complex and unexpected cases that can occur during the life of the fund. We will cover a few examples and understand how to handle such situations or how such situations are handled in a fund.

Suppose an LP comes up and asks for split in its capital commitment. This means that he would like to share his commitment with some other LP in a defined ratio. In that case all the previous contributions (draw downs), expenses, investments, undistributed incomes of the original will be re-allocated among the new ratios between these LP's. How to handle distributed income remains in the hands of people involved in the split because that amount is already in the hands of original LP.

Let us understand with numbers, the case of split.

The last figures as per continuing example from my previous posts that we had are as follows:

	CC	CC Ratio	Drawdown	Investment	Mgmt Fees	Deal Exp	Non Deal Exp	Cash Balance
LP 1	10	7%	2	1.00	0.2	0.07	0.07	0.67
LP 2	20	13%	4	2.00	0.4	0.13	0.13	1.33
LP 3	30	20%	6	3.00	0.6	0.20	0.20	2.00
LP 4	25	17%	5	2.50	0.5	0.17	0.17	1.67
LP 5	15	10%	3	1.50	0.3	0.10	0.10	1.00
LP 6	50	33%	10	5.00	1	0.33	0.33	3.33
	150		30	15	3	1	1	10

Now suppose LP #6 decides to split his commitment among himself and a new LP, LP #7. (Note that split can happen between existing as well as new LP's.) He decides to keep a capital commitment of 30 wheres decides to pass on capital commitment of 20 to the new LP #7.

The new figures will be calculated on a pro rata basis between the 2 LP's. Let us see how their holdings and allocations change:

	CC	CC Ratio	Drawdown	Investment	Mgmt Fees	Deal Exp	Indirect Exp	Cash Balance
LP 1	10	7%	2	1.00	0.2	0.07	0.07	0.67
LP 2	20	13%	4	2.00	0.4	0.13	0.13	1.33
LP 3	30	20%	6	3.00	0.6	0.20	0.20	2.00
LP 4	25	17%	5	2.50	0.5	0.17	0.17	1.67
LP 5	15	10%	3	1.50	0.3	0.10	0.10	1.00
LP 6	30	20%	6	3.00	0.6	0.20	0.20	2.00
LP 7	20	13%	4	2.00	0.4	0.13	0.13	1.33
	150		30	15	3	1	1	10

In practical scenario, a split happens most of the times between husband and wife, to reduce the burden of tax on profits.

There can be cases where an LP defaults or does not intend to pay any drawdown amount from now on. These cases can be handled in a variety of ways. In most cases, the Contribution Agreement of the fund also gives a lot of flexibility in handling such cases. A lot of options are mentioned and one of those can be executed in case of a default.

Options like

capping his capital commitment to that extent where the capital commitment of the whole fund reduces by the amount unpaid by that LP.
returning only his contributed amount and not the profit portion on that amount while distributing in the end.
forfeit all his amount.
return some percentage of the amount contributed by him.
in some cases, he will be a part of all future expenses (not investments) as well by the cash portion remaining and the profits on his investments will be allocated to other LP's and not to him.
any other options as per the funds discretion.

Indirect Incomes and closings

2011-10-15T21:30:00.000+05:30

Let us understand a basics of different Indirect Incomes that can be generated during the life of the fund.

There can be Premium Income generated from LP that has entered in a subsequent closing.

For understanding this, let us understand what is a closing.

Whenever AMC asks for a draw down from all investors, it is referred to as a closing. A fund can have one or more closings. After the final closing is declared, no more money can be drawn down from the investors even if there is still some uncalled amount out of the commitment amount previously decided for the LP's.

Now suppose that a few LP's have invested in the first closing. The first closing happens at the start of the fund for the fund to have some cash for meeting expenses and investment needs. Then as and when the fund finds good investment horizons, it asks for further drawdowns.

Now suppose a new investor decides to enter the fund at the second or some subsequent closing. He will be asked to pay a premium which will be allocated to all the LP's that were present in the previous closings.

This new LP will take a place in all the previous expenses as well as investments. He will be treated as if he was in the fund from the very start. This means that the other LP's investment holdings in the previous investments will reduce as they make place for this LP. Let us understand this with the help of numbers.

An equal percentage of drawdown will be taken from this new LP to get it on par with other LP's. The previous (before entry of new LP) allocation of expenses and investments at LP level are as follows:

	CC	CC Ratio	Drawdown	Investment	Mgmt Fees	Deal Exp	Indirect Exp	Cash Balance
LP 1	10	10%	2	1.50	0.2	0.10	0.10	0.10
LP 2	20	20%	4	3.00	0.4	0.20	0.20	0.20
LP 3	30	30%	6	4.50	0.6	0.30	0.30	0.30
LP 4	25	25%	5	3.75	0.5	0.25	0.25	0.25
LP 5	15	15%	3	2.25	0.3	0.15	0.15	0.15
	100		20	15	2	1	1	1

After the new LP (LP #6) comes in with a capital commitment of 50 and contributes 20% to be in par with other investors, the re-allocation of numbers based on the new Capital Commitment (CC) ratio will be as follows:

	CC	CC Ratio	Drawdown	Investment	Mgmt Fees	Deal Exp	Indirect Exp	Cash Balance
LP 1	10	7%	2	1.00	0.2	0.07	0.07	0.67
LP 2	20	13%	4	2.00	0.4	0.13	0.13	1.33
LP 3	30	20%	6	3.00	0.6	0.20	0.20	2.00
LP 4	25	17%	5	2.50	0.5	0.17	0.17	1.67
LP 5	15	10%	3	1.50	0.3	0.10	0.10	1.00
LP 6	50	33%	10	5.00	1	0.33	0.33	3.33
	150		30	15	3	1	1	10

One thing to be noted is that the Management fees total amount was increased because this fees is calculated as a percentage of LP's Capital Commitment. So others previous and new Management Fees was the same, just the new Management Fees of the new LP got added to those.

Now as the new LP gets a part in all the old investments, whose value must have increased over the time. The new LP takes part in them and the holdings of old investors is reduced in it, as we can confirm with the above numbers.

To compensate the old LP's for reduced share in these investments and for the increased value of these investments, the fund charges Premium Amount to that LP which is allocated to other LP's why were present in the previous closing. This amount is generally a percentage of amount contributed by the LP in that closing and is generally mentioned in the Contribution Agreement.

But practically what we have seen is, the AMC waives premium charges to the incoming LP to maintain good relations with the new investor.

Now let us understand Late fees Income for the fund.

Whenever a drawdown call is sent to LP's, it goes with a call date (when the drawdown is generated) and a due date (deadline for the amount to be paid). If an LP pays after the due date, he is subjected to pay a Late Fees which is allocated to other LP's. In some rare cases, we have seen that this income is allocated to all the LP's including the one who pays it. And in practical scenario, this fee is generally waived by the fund to maintain good investor relations.

General Indirect Income

Other Indirect Incomes can be generated through some short term investments that the fund must have made with the extra cash lying with it, before that was invested in the portfolio companies.

Distribution

2011-09-30T04:42:00.000+05:30

Now comes the time when the invested amount is sold off and money is to be returned to the investors (LP's). The most common method used for that is the waterfall model. A waterfall is the priority in which money is returned on an investment. The most basic version of waterfall model for distribution of capital back to the investors is as follows:

Invested Capital to LP

PR (interest on the capital) to LP

Catch up to GP

Profits (Carry)

---------------------

| |

80% to LP 20% to GP

Hence the GP generates any of profits only if the value of capital is more than the invested amount and preferred return (sometimes also referred to as hurdle rate or interest) which is first returned to the investor (LP).

An example of a very simple waterfall would be:

- LP's receive all distributions until they have been returned their capital (GP also gets capital returned for its contribution, but no carry at this point)

- LP's receive 80% of distributions and GPs receive 20% of remaining distributions,

Often fund will offer LP's a guaranteed return before they take their carry, though they get a catchup after the guaranteed return. So this is a common waterfall:

- LP's receive all their capital.

- LP's receive distributions until the return they have is 10% of contributed capital. (this is known as the hurdle or PR)

- GP receives 100% of distributions until the GP has received an amount equal to 20% of 2 (this is known as the catch up).

- LP's receive 80% of distributions and GP receives 20% of distributions

If a privat equity fund is like a venture capital fund or a buy out fund, then over many many small plays they make 8 to 10 large plays. Then the question is whether capital is returned on a case by case basis or on an overall basis. Some private equity funds ask for multiple hurdles (i.e., it won't collect anything until you get 10% but after you get more than 20% on your money it wants more than 20% carry).

The PPM (Private Placement Memorandum) should outline the waterfall and the LP agreement section on distributions should cover the waterfall

Complexities in Distribution

2011-09-28T08:06:00.000+05:30

Distribution appears simple in the waterfall model shown in the above post. But it is not always so simple and straight forward, especially when its a retail private equity fund, i.e. a private equity fund with retail investors. With retail investors investing in the fund, the minimum amount that is committed by each investor is less and the number of investors are many. Handing data of so many investors becomes a problem because every information of their late fees, contribution dates, PR to be paid to them based on the date they deposited, etc etc. come into picture.

If the investor had contributed for a draw down later than the due date for that draw down, the interest on his contribution will start accruing from the date that he contributed. So the interest for this one single investor will be different as compared to all other investors. With funds over 200 investors, this becomes a tedious task. Various softwares, websites or huge excel files with numerous sheets are used to capture such data and calculate the distribution amount based on these combinations.

Also for various contributions, the date from when the interest or PR amount will be calculated will be different. So for every investor, interest will be calculated on various contributions for different amounts and different periods. Let us make it simpler with the help of an example.
We will understand this with the help of just one investor

Mr. A commits 200 in fund XYZ.
For the 1st draw down for 30% he contributes 60 on 01 Jan 2011.
For the 2nd draw down that was for 20% he contributes 40 on 01 April 2011.
For the 3rd draw down that was for 40% he contributed 80 on 01 July 2011.

The value of his invested capital (180) became 300 and was all realized on 01 Jan 2013.

If the PR is at 10%, it will be calculated as follows.
PR = 10% of 60 for 2 years + 10% of 40 for 1 year and 9 months and 10% of 80 for 1 and a half year.

It also depends if the cumulative quarterly, half yearly or annually, on how the PR will be calculated.

This was just the PR calculation for one investor. Imagine the calculation of PR for the whole fund. And this is just the second stage of the distribution waterfall.

It also depends on how the funds are invested and are meant to be distributed, for example the funds from 2 draw downs can be invested into 2 different portfolio companies or the 2nd draw down can be a follow up investment into the same portfolio company where the first draw down money was invested. There are also costs associated in it which are over the invested amount and are taken out from the contributed capital. It also depends on the type of distribution, whether it is a case by case (also known as deal by deal) distribution or non deal by deal distribution. We will understand the details of these two types of distributions in detail in further blogs.

Disbursement or Investment in a Portfolio Company

2011-09-25T21:29:00.000+05:30

Now that the money is drawn down from the LP's, the fund will invest in the company. As per our numbers, the fund had to invest 15 in a portfolio company. Investment in a company is also referred to as disbursement.

There might be some deal and indirect expenses that might have happened.

Deal expenses are those that can be directly associated against a deal, and indirect expenses are those that cannot be associated against a deal.

For Example: If there has been some due diligence activity for the company to be invested in, or travelling expenses as a part of finalizing the deal, those charges can be associated directly against the deal. These are classified as deal expenses and these are allocated to LP's in a ratio in which they are participating in the deal.

Expenses like electricity bill of the AMC, salaries of employees of AMC, cannot be allocated against a single deal. These must be spread across all the deals and must be allocated to all deals in their invested amount proportion. Such expenses are hence referred to as indirect Expenses.

Drawn Down Money:	20
Investment Amount:	15
Management Fees:	2
Deal Expenses:	1
Indirect Expenses:	1
Cash Balance:	1

Let us see how all these expenses and investments are allocated to each LP.

Management Fees and Classes of LP's

2011-09-18T21:28:00.000+05:30

Management Fee's is charged by the AMC to the LP's (investors) as a fees for managing their fund.

There can be different ways in which the management fees is charged. To understand that, let us first understand the commitment period and post commitment period of the fund life cycle.

The fund life cycle is divided into commitment period and post commitment period.

In most cases, Commitment period is defined as the time before which the AMC is allowed to drawdown money from LP's and invest them. After the post commitment period, no money can be drawn down from LP's and no further investments (disbursements) can be made into any portfolio company. Based on the contribution agreement, small modifications in the handling of these definitions are seen in the case of some funds.

In most common scenarios, AMC charges some percentage of management fees on Capital Commitment during the investment period and later on Capital Contributed or Remaining Invested Capital.
Remaining Invested Capital can have all or few components out of the following-->

Invested amounts to portfolio companies
Deal Expenses incurred towards portfolio companies
Indirect fund expenses incurred
Management fees charged to the fund
Cash balance if any

Now let us understand with the same set of numbers, how management fees can be charges in commitment as well as post commitment period. Let us assume that the management fees charged is 2% of to total capital commitment during Commitment Period.

Management Fees (2%) charged during Commitment Period on total Capital Commitment

	CC	Management Fees (2%)
LP 1	10	0.2
LP 2	20	0.4
LP 3	30	0.6
LP 4	25	0.5
LP 5	15	0.3
	100

This is the annual management fees taken from each LP. In most cases, the AMC charges management fees on a quarterly basis in advance, at the start of every quarter.

An overview of the complete life cycle of a fund

2011-09-10T21:28:00.000+05:30

The Asset Management Company (AMC) finalizes the Contribution agreement and PPM which will have all the clauses and defined terms which are to be followed throughout the life of the fund for carrying our various operations.

Investors or Limited Partners (LP's) would commit to invest in one or more of the funds floated by the AMC.

By committing towards the fund means that they have promised to pay a defined sum of amount towards that fund, which they might not have paid upfront. The AMC company has the right to ask for that amount in parts by sending out draw down (or capital call) notices to investors till the total committed amount has been drawn down.

For a fund, there will be many Investors (LP's - Limited Partners). In case of a fund with Institutional Investors, there are generally 10-20 investors contributing towards the total fund size while in case of Retail Investors, there have been cases with more than 2000 investors investing in the same fund.

From hereon, let us understand these terms with the help of numbers.

Suppose a private equity company XYZ plans to start a fund with a fund size of 100.

5 LP's commit 10, 20, 30, 25, 15 for that fund.

So their capital commitment ratio will be calculated based on the amounts.

	CC	CC Ratio
LP 1	10	10%
LP 2	20	20%
LP 3	30	30%
LP 4	25	25%
LP 5	15	15%
	100

In most cases, all drawdowns, investments, expenses and incomes arising are allocated against each LP on the basis of their capital commitment ratio.

To understand that better, Assume that the fund find a very good investment opportunity. It plans to invest 15 into a portfolio company. It decides to ask for 20% of the capital commitment amount (or 20 in amount) from all investors considering the extra expenses that might be incurred by the fund and some extra cash balance for meeting regular expenses like management fees, etc.

In that case the amounts drawn down from each LP will be calculated as follows:

	CC	CC Ratio	Drawdown / Capital Call	Drawdown for LP's
LP 1	10	10%	20 % of 100 = 20	20% * 10 = 2
LP 2	20	20%		20% * 20 = 4
LP 3	30	30%		20% * 30 = 6
LP 4	25	25%		20% * 25 = 5
LP 5	15	15%		20% * 15 = 3
	100			20

What is a Private Equity Fund?

2011-08-10T02:31:00.000+05:30

Private equity is a type of alternative investment that involves investing in privately held companies. For most investors, private equity investing is accomplished through illiquid, long-term partnerships, also referred to as funds that are formed by private equity firms. Funds are generally closed end with 10-15 year lives, which require investing with a long-term horizon.

In layman terms, Private Equity fund is like any other fund where money or capital is collected from various investors and combined together to invest into real estate, equity, bonds and other funds or products for growth of the capital.

It has a very organized way of deciding how much money can be collected by an investor, collecting money in parts, most commonly based on percentages, investing money into products with the knowledge of money invested into each product by every single investor, and then selling those products at the right time to get maximum benefit for the investors and also for the company managing the private equity fund. When the funds a sold off, the profits are distributed between the investor and private equity company in a ratio (most commonly seen to be 80:20).

It appears to be simple mathematics when looking at the above process. But this process has various complexities and exceptions. Let us understand a few simple terms so that it becomes simple to understand the operations of Private Equity industry going ahead.

Capital Commitment - The maximum amount promised by an investor to invest in this fund.
Capital Contribution - The amount that the investor has invested so far.
Limited Partner (LP) - Another name of Investor
General Partner (GP) - The trustee, Asset Management Company or Private Equity Company itself.

An investor commits a maximum amount that he will invest throughout the life of the fund. That becomes his capital commitment amount and the total capital commitment amount of all the investors makes the total capital commitment amount for the fund. It is not mandatory for the fund to ask from the investor and invest all the amount that he has committed.

Now to start with the fund, a contribution amount is decided, that will be drawn down (taken) from each investor. It depends on the expenses of the fund (salary, brokerage, etc) and also on the investment opportunities available at that time. It is generally a percentage (10% to 40%) of the capital commitment amount. From the day money is contributed into the fund, a preferred return (interest) keeps accumulating in the fund that is to be returned to the investor before any other profits are shared between the investor (LP) and the private equity company (GP). i.e. If I invest $10 into a fund whose value becomes $17 after 2 years and whose PR (interest rate) is 10% on a non cumulative basis. When the money is realized by selling the products, first I will receive my $10, then the 2 years of non cumulative interest on $10, i.e. $2, and then on the remaining $5 profits a sharing between the company and me will be done.

I will try and not make it too complex at the beginning. Lets start with a few simple concepts and learn with the help of examples and tables to understand the operations in a private equity company in detail.