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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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10/29/2012

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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 used to invest, they have very different objectives and target different opportunities. At their most fundamental level, hedge funds, private-equity funds and venture capital funds are like mutual funds. They all gather cash from investors, pool it and invest the money in businesses expected to become more valuable over time. The differences have to do mainly with the types of investors and the types of companies the funds invest 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're allowed to invest in just about anything. Typically, hedge fund managers are traders more 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 are free to sell short — that is, bet against assets and profit if the value of the asset falls in value. • Private-equity funds. Remember the leveraged-buyout firms of the 1980s? If you remember LBOs, private-equity firms are the same thing. These investors take investment money from large institutions, like public pension funds, and borrow additional 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 are parachuted 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 histories or products get the money they need to start up? Launching a semiconductor or biotechnology firm can be expensive and beyond the credit card limit of any entrepreneur. That's where venture capital, or VC, firms come in. These firms take money from institutional investors, like pension funds, and make relatively small investments in scores of small upstarts. Most of the investments will go down the drain as the firms implode and never make a dime. But if VC firms do their homework, they'll more than make up for the losses with just a few home runs. VCs that bankroll the next Microsoft or Google will make tremendous returns on their investment despite the risk of funding other companies that fail. As you can see, each type of fund is different. They're all considered "alternative investments" because they operate differently than mutual funds that buy stocks traded on the major exchanges. But in the end, the goal is the same: To get a solid return for the 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 unfunded commitment to the limited partnership, which is then drawn over the term of the fund.

investor. Typically, such a transfer must receive the consent of and is at the discretion of the fund's manager

Restrictions on the General Partner - the fund's manager has significant discretion to make investments and control the affairs of the fund. However, the LPA does have certain restrictions and controls and is often limited in the type, size or geographic focus of investments permitted and how long the manager is permitted to make new investments

Leveraged buyout, LBO or simply Buyout: refers to a strategy of making equity investments as part of a transaction in which a company, business unit or business assets is acquired from the current shareholders typically with the use of financial leverage. The companies involved in these transactions are typically more mature and generate operating cash flows. Highly-leveraged transaction or "bootstrap" transaction occurs when a financial sponsor acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. This kind of acquisition brings leverage benefits to an LBO's financial sponsor in two ways: (1) the investor itself only needs to provide a fraction of the capital for the acquisition, and (2) assuming the economic internal rate of return on the investment (taking into account expected exit proceeds) exceeds the weighted average interest rate on the acquisition debt, returns to the financial sponsor will be significantly enhanced. 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 may be used as collateral for lower cost secured debt; The potential for new management to make operational or other improvements to the firm to boost cash flows; Market conditions and perceptions that depress the valuation or stock price.

• • • • •

Term of the partnership – the partnership is usually a fixed-life investment vehicle that is typically 10 years plus some number of extensions Management fees – an annual payment made by the investors in the fund to the 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 performance incentive. 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 be achieved before the fund manager can receive any carried interest payments Transfer of an interest in the fund – private equity funds are not intended to be transferred or traded, however they can be transferred to another

Venture capital: a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business. Venture capital is often sub-divided by the stage of development of the company ranging from early stage capital used for the launch of start-up companies to late stage and growth capital that is often used to fund expansion of existing business that are generating revenue but may not yet be profitable or generating cash flow to fund future growth. Growth capital: refers to equity investments, most often minority investments, in more mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.

Limited Partnerships: LPs form of partnership similar to a general partnership, except that in addition to one or more general partners (GPs), there are one or more limited partners (LPs). As in a general partnership, the GPs have actual authority as agents of the firm to bind all the other partners in contracts with third parties that are in the ordinary course of the partnership's business. Like shareholders in a corporation, LPs

have limited liability, meaning they are only liable on debts incurred by the firm to the extent of their registered investment and have no management authority. The GPs pay the LPs a return on their investment (similar to a dividend), the nature and extent of which is usually defined in the partnership agreement.

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