Mastering Private Equity. Prahl Michael
individual LP’s liability limited to the capital committed to the fund. Investors active in PE include private and public pension funds, endowments, insurance companies, banks, corporations, family offices, and fund of funds.6 LPs are purely financial investors and cannot be involved in the day-to-day operation or management of the fund or its investee companies without running the risk of forfeiting their limited liability rights. LPs legally commit to provide capital for investment when it is drawn down (or “called”) by the PE fund and they receive distributions of capital – including a share of profits – upon successful exit of the fund’s investments.
GENERAL PARTNER: A fund’s GP is wholly responsible for all aspects related to managing the fund and has a fiduciary duty to act solely in the interest of the fund’s investors. It will issue capital calls to LPs and make all investment and divestment decisions for the fund in line with the mandate set out in its Limited Partnership Agreement (LPA). The GP may delegate some of the management functions to the investment manager or a PE firm’s investment committee (IC),7 but remains fully and personally liable for all debts and liabilities of the fund and is contractually obligated to invest the fund’s capital in line with its mandate.8 A GP – and in turn a PE firm’s partners and senior professionals – will also commit capital to the fund to align its interest with that of the fund’s LPs by ensuring that the firm’s partners have “skin in the game”; the GP stake typically ranges from 1 to 5 % and rarely exceeds 10 % of a fund’s total capital raised.
INVESTMENT MANAGER: In practice, the investment manager9 conducts the day-to-day activities of a PE fund; it evaluates potential investment opportunities, provides advisory services to the fund’s portfolio companies, and manages the fund’s audit and reporting processes. The manager is paid a management fee by the fund for providing these services, some of which may be passed on to a subadvisor. The management fee is typically set at around 1.5−2 % of committed capital during the investment period of the fund; after the end of the investment period, it is calculated on invested capital and may step down to a lower rate. More information on fee structures can be found later in this chapter.
PORTFOLIO COMPANY: Over its lifecycle, a PE fund will invest in a limited number of companies, 10−15 on average, which represent its investment portfolio. These companies are also referred to as investee companies or (during the due diligence process) as target companies. A PE firm’s ability to sell its stakes in these companies at a profit after a three- to seven-year holding period will determine the success or failure of the fund.
From the perspective of the PE firm and its affiliated entities, the business of PE comes down to two simple yet distinct relationships: on the one hand, the firm’s fiduciary duty towards its LPs and on the other hand its engagement with entrepreneurs, business owners and management teams in its portfolio companies (Exhibit 1.2). Establishing a reputation of professional conduct and value-add will ensure access to both future fundraising and investment opportunities.
Exhibit 1.2 Key Relationships GPs Must Manage
THE GP PERSPECTIVE
LIFECYCLE OF A PE FUND
A traditional PE firm’s business model relies on success in both raising funds and meeting its target return by effectively deploying and harvesting fund capital. PE funds structured as limited partnerships are typically raised for a 10-year term plus two one-year extensions, commonly referred to as the “10+2” model. Generally speaking, a GP will deploy capital during the first four to five years of a fund’s life and harvest capital during the remaining years. The two optional years allow the GP to extend a fund’s lifespan at its discretion if and when additional time is needed to prudently exit all investments.
Exhibit 1.3 shows the overlapping timelines for the fundraising, investment, holding, and divestment periods of a closed-end fund.
Exhibit 1.3 Lifecycle of a PE Fund
FUNDRAISING: PE firms raise capital for a fund by securing capital commitments from investors (LPs) through a series of fund closings.10 A PE firm will establish a target fund size from the outset – at times defining a “hard cap” to limit the total amount raised in case of excess investor demand. Once an initial threshold of capital commitments has been reached, the fund’s GP will hold a first closing, at which time an initial group of LPs will subscribe to the fund and the GP can start to deploy capital. A fund holding its first closing in 2016 is referred to as a “vintage 2016 fund,” a fund with a first closing in 2017 will be known as a “vintage 2017 fund,” and so on. Fundraising will typically continue for a defined period – 12 to 18 months – from the date of the first closing until the fund reaches its target fund size and a “final closing” is held. The total amount raised by a PE firm is known as a fund’s committed capital.
INVESTMENT PERIOD: Rather than receiving the committed capital on day one, a GP draws down LP commitments over the course of a fund’s investment period. The length of the investment period is defined in a fund’s governing documents and typically lasts four to five years from the date of its first closing; a GP may at times extend the investment period by a year or two, with approval from its LPs. Once the investment period expires, the fund can no longer invest in new companies; however, follow-on investments in existing portfolio companies or add-on acquisitions are permitted throughout the holding period. A fund’s LPA may also permit its GP to finance new investments from a portion of fund realizations within a certain limited period after divestment (this is known as the recycling of capital), thus increasing a fund’s total investable capital.
GPs draw down investor capital by making “capital calls” to fund suitable investment opportunities or to pay fund fees and expenses. LPs must meet capital calls within a short period, typically 10 business days. If an LP fails to meet a capital call, various remedies are available to the GP. These include the right to charge high interest rates on late payments, the right to force a sale of the defaulting LP’s interest on the secondaries11 market and the right to continue to charge losses and expenses to the defaulting LP while cutting off their interest in future fund profits. The portion of LPs’ committed capital that has been called and invested is referred to as contributed capital. A fund’s uninvested committed capital is referred to as its “dry powder”; by extension, the total amount of uninvested committed capital across the industry is referred to as the industry’s “dry powder.” Exhibit 1.4 shows the increase of the industry’s dry powder since 2000; the 2015 data adds perspective on its origin by grouping dry powder according to vintage year.12
Exhibit 1.4 PE Industry Dry Powder
Source: Preqin
HOLDING PERIOD: Holding periods for individual portfolio companies typically range from three to seven years following investment, but may be significantly shorter in the case of successful companies or longer in the case of under-performing firms. During this time, a fund’s GP works closely with portfolio companies’ management teams to create value and prepare the company for exit.13
DIVESTMENT
A fund of PE funds (fund of funds) is a vehicle that invests in a portfolio of individual investment funds. A fund of funds offers clients diversified exposure to the PE asset class without the need for deep investment expertise or lengthy due diligence on the individual funds. An additional layer of fees applies.
The IC is typically a committee of the GP and makes the binding investment and divestment decisions for the fund under delegated authority from the GP (“binding” in the sense that once the IC votes, there is no other vote needed or taken).
GPs are usually set up as distinct special purpose vehicles (SPVs) for each fund; these SPVs serve as the GP for only one fund to avoid cross-liabilities between related funds of the PE firm. Please refer to Chapter 16 for further details on fund formation.
Investment managers will also be referred to as advisors or simply managers.
Please refer to Chapter 24 Private Equity Secondaries for further details on the mechanics behind the transfer of such LP stakes.