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Private Equity Basics

Private Equity Basics

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Published by: James on Jun 03, 2009
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You've probably heard of many types of alternative investments, such as hedge funds,private-equity funds and venture capital funds. While all three are pools of money usedto invest, they have very different objectives and target different opportunities.At their most fundamental level, hedge funds, private-equity funds and venture capitalfunds are like mutual funds. They all gather cash from investors, pool it and invest themoney in businesses expected to become more valuable over time. The differenceshave to do mainly with the types of investors and the types of companies the fundsinvest in. Here is a quick explanation:
Hedge funds.
These are pools of money that largely fly under the radar of regulators.Since they only accept money from investors with plenty of cash to lose, they'reallowed to invest in just about anything. Typically, hedge fund managers are tradersmore than investors. They're looking to take a big position in an asset, be it a stock,commodity or foreign currency, hold it for a short time and sell it. Hedge funds also arefree to sell short — that is, bet against assets and profit if the value of the asset falls invalue.
Private-equity funds.
Remember the leveraged-buyout firms of the 1980s? If youremember LBOs, private-equity firms are the same thing. These investors takeinvestment money from large institutions, like public pension funds, and borrowadditional cash so they can buy both private and public companies. Unlike hedge funds,though, private-equity firms generally have a stable of business experts who areparachuted into companies to fix them or break them up and sell them for a profit.
Venture capital firms.
Ever wonder how young companies with no business historiesor products get the money they need to start up? Launching a semiconductor orbiotechnology firm can be expensive and beyond the credit card limit of anyentrepreneur. That's where venture capital, or VC, firms come in. These firms takemoney from institutional investors, like pension funds, and make relatively smallinvestments in scores of small upstarts. Most of the investments will go down the drainas the firms implode and never make a dime. But if VC firms do their homework, they'llmore than make up for the losses with just a few home runs. VCs that bankroll the nextMicrosoft or Google will make tremendous returns on their investment despite the riskof funding other companies that fail.As you can see, each type of fund is different. They're all considered "alternativeinvestments" because they operate differently than mutual funds that buy stocks tradedon the major exchanges. But in the end, the goal is the same: To get a solid return forthe risk that's taken.Private equity funds are typically limited partnerships with a fixed term of 10 years(often with annual extensions). At inception, institutional investors make an unfundedcommitment to the limited partnership, which is then drawn over the term of the fund.
Term of the partnership
– the partnership is usually a fixed-life investmentvehicle that is typically 10 years plus some number of extensions
Management fees
– an annual payment made by the investors in the fund tothe fund's manager to pay for the private equity firm's investment operations
Carried interest
- a share of the profits of the fund (typically up to 20%),paid to the private equity fund’s management company as a performanceincentive. The remaining 80% of the profits are paid to the fund's investors[1]
Hurdle Rate
or preferred return– a minimum rate of return which must beachieved before the fund manager can receive any carried interest payments
Transfer of an interest in the fund
– private equity funds are not intendedto be transferred or traded, however they can be transferred to anotherinvestor. Typically, such a transfer must receive the consent of and is at thediscretion of the fund's manager
Restrictions on the General Partner
- the fund's manager has significantdiscretion to make investments and control the affairs of the fund. However,the LPA does have certain restrictions and controls and is often limited in thetype, size or geographic focus of investments permitted and how long themanager is permitted to make new investments
Leveraged buyout
, LBO or simply Buyout: refers to a strategy of making equityinvestments as part of a transaction in which a company, business unit or businessassets is acquired from the current shareholders typically with the use of financialleverage. The companies involved in these transactions are typically more mature andgenerate operating cash flows.
Highly-leveraged transaction
or "
" transaction occurs when a financialsponsor acquires a controlling interest in a company's equity and where a significantpercentage of the purchase price is financed through leverage (borrowing). The assetsof the acquired company are used as collateral for the borrowed capital, sometimeswith assets of the acquiring company. The bonds or other paper issued for leveragedbuyouts are commonly considered not to be investment grade because of the significantrisks involved.This kind of acquisition brings leverage benefits to an LBO's financial sponsor in twoways: (1) the investor itself only needs to provide a fraction of the capital for theacquisition, and (2) assuming the economic internal rate of return on the investment(taking into account expected exit proceeds) exceeds the weighted average interestrate on the acquisition debt, returns to the financial sponsor will be significantlyenhanced.
Characteristics of LBO Target:
Low existing debt loads;
A multi-year history of stable and recurring cash flows;
Hard assets (property, plant and equipment, inventory, receivables) that maybe used as collateral for lower cost secured debt;
The potential for new management to make operational or otherimprovements to the firm to boost cash flows;
Market conditions and perceptions that depress the valuation or stock price.
Venture capital
: a broad subcategory of private equity that refers to equityinvestments made, typically in less mature companies, for the launch, earlydevelopment, or expansion of a business. Venture capital is often sub-divided by thestage of development of the company ranging from early stage capital used for thelaunch of start-up companies to late stage and growth capital that is often used to fundexpansion of existing business that are generating revenue but may not yet beprofitable or generating cash flow to fund future growth.
Growth capital
: refers to equity investments, most often minority investments, inmore mature companies that are looking for capital to expand or restructureoperations, enter new markets or finance a major acquisition without a change of control of the business.

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