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How does private equity work?

Understanding private equity and private markets doesn’t just mean understanding the structure of a fund. It means understanding what happens at each point in a fund’s life, why, and what that means for investors and the fund’s management alike.

This section begins with a reminder of the structure of a private equity fund and how it operates, followed by a detailed look at the life of a fund from formation to the close, highlighting the roles of the General Partner and Limited Partners at each stage. Finally, we will cover how the nature of a fund’s life leads to a unique return profile (the J-Curve), diversification consequences and how the secondary market can offer a solution for investors seeking liquidity.

The structure of a private equity fund

We covered the basic structure of a private equity fund in What is private equity?, but here is a quick refresher of the key parties before going through how they interact.

A private equity fund is a pool of capital used to invest in private companies that fit within a predetermined investment strategy.

The fund is managed by a private equity firm known as the ‘General Partner’ of the fund. By contributing, investors become ‘Limited Partners’ of the fund. As such, the fund is known as a ‘Limited Partnership’. 

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Why is the Limited Partnership structure used?

Tax benefits. A Limited Partnership is - as the name suggests - treated as a partnership as opposed to a corporation. This means that the only tax responsibility is at the investor level. If it were a corporate entity (such as a ‘C corporation’ in the United States) then the fund would pay tax at both the corporate and the investor (dividend) level.

General Partner control. The primary expertise of a private equity firm lies in managing a fund, so the Limited Partners delegate all control to the General Partner. The only exception comes in the form of Limited Partner Advisory Committees ("LPACs") which the General Partner can call on for advice at their discretion.

Limited Liability. Since the Limited Partners are not involved in managing the fund, their liability for losses is limited. This means that the maximum loss they can suffer is the total value of their own committed capital (though this is extremely rare), while the General Partner takes on all liability. Private equity firms generally shield the individuals within the firm from this liability by structuring themselves as Limited Liability Companies (“LLCs”)

Tried-and-tested. The Limited Partnership structure has been in operation within the private equity industry for many decades now and has proven beneficial for all parties. It’s becoming increasingly popular to structure the funds themselves as an LLC (not just the General Partner) as they offer even greater flexibility, especially from a tax perspective.

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The timeline of a private equity fund

As explained above, we have four key parties involved in the life of a fund:

  1. The General Partner - a private equity firm
  2. The Limited Partnership - the private equity fund
  3. Limited Partners - investors in the private equity fund
  4. Companies - the recipients of investment from the fund

The technical life of a fund is called the Fund Term. Unlike public equity funds - which usually operate on a rolling basis - the Fund Term is finite. The most common term is ten years, with optional extensions (usually two or three years).

Note: This timeline is just for illustration. Each fund has a different schedule (particularly when it comes to the investment period and number of extensions), the details of which are laid out in the Offering Materials (more below). Also, the investment and harvesting periods are not clearly defined: they overlap heavily. For example, an investment made early on may begin providing cash flows to the fund before later deals have even closed. Finally, the fund term can be extended beyond the term laid out in the formation materials.

Now, we will cover the three parts of the fund’s life: Formation, Investment and Harvesting. 

Please note: For Moonfare investors, the process of becoming a Limited Partner is simplified and automated through the Moonfare platform. Click here to learn more about how private equity investing works with Moonfare.

1. Formation

This is the period before the fund launches, when the soon-to-be General Partner will go through a series of steps, some of which will involve the soon-to-be Limited Partners. For ease, we’ll refer to the “private equity firm” as “General Partner” and “investors” as “Limited Partners” here, even though those names will not technically apply until the end of the formation phase.

The formation stage can take anywhere from a few years to a decade - depending on the experience level of the fund and a myriad of factors. For seasoned private equity firms, this is a rolling process meaning that the plans for forming the next fund are in development relatively early on in the previous fund’s life. 

Strategy development (GP). The General Partner develops a clear strategy that will guide the management of the fund. For a new fund, this strategy might have been discussed for years before the launch. For more experienced firms - for whom this might be their seventh or seventeenth fund in the same strategy - it can be a simple refinement of what has worked previously. That said, firms will often refresh their strategy, reacting to a changing market.

Offering materials (GP). The General Partner produces all of the materials that are legally required before launching a fund, as well as those to attract prospective Limited Partners in the next phase. These lay out everything about the fund and generally come in the form of three main documents in decreasing level of detail:

Private Placement Memorandum (“PPM”). This is the document that contains everything about the Limited Partnership the General Partner is setting up. It lays out all details about the fund - whether legally-required elements or essential reading for Limited Partners.

Here are the standard sections in private equity PPM (for illustrative purposes):

  1. Executive summary
  2. Investment performance 
  3. Summary of Key Fund Terms 
  4. General Partner Overview 
  5. Investment Team
  6. Investment Strategy 
  7. Industry Opportunity 
  8. Key Fund Terms 
  9. Appendices

Due Diligence Questionnaire. Limited Partners need to carry out their own due diligence on a possible investment. Since General Partners are usually asked to fill out a questionnaire for investors, they will usually produce their own in advance to pre-empt requests. They follow a similar structure to the PPM, but are usually around 100 pages, targeted specifically at potential investors.

Marketing Presentation. These are a heavily distilled version of the PPM, putting forward each of the sections mentioned above as well as highlighting arguments for Limited Partners to commit capital. Since they are designed to garner interest instead of containing all information, they usually run in the region of 30-50 slides.

Fundraising (GP & LP). This is where the General Partner announces that the fund is launching and puts out a call for Limited Partners to commit capital to the fund. This part can take anywhere from a matter of months (for seasoned firms with existing relationships and a proven track record) or many years (for new firms who are not yet established).

Since there are numerous Limited Partners in a given fund, it is a stage of back-and-forth between the General Partner and prospective Limited Partners, answering questions and possibly negotiating fund documents.

Investor due diligence (LP). Potential limited partners carry out their own due diligence on private equity managers. This is effectively the other side of the back-and-forth described above, but it is worth calling it out here to stress how important it is for any investor.

Development of deal pipeline (GP and companies). During - and often before - fundraising, the General Partner will be attending to the other side of the coin: looking into prospective companies to invest in once the fund launches. If deals are already made before the fund has finished raising capital, the investments are “warehoused” and are often used to help sell the fund to investors.

Initial closing (GP and LP). Fundraising ends on the “initial closing” date (specified in the Offering materials) at which point the “initial closing period” begins, during which Limited Partners are admitted to the fund before the investment period begins. Most funds accept new Limited Partners after the initial closing date (often for around 12 months), technically overlapping the fundraising period with the investment period.

2. Investment

As soon as the fund documents are signed, investors become Limited Partners and the General Partnership is born. This is also when the “Investment Period” begins - usually three to five years - the expected length of which is laid out in the offering materials.

Management fees (LP and GP).  After Limited Partners have made their commitment to the fund, the General Partner begins charging management fee on their commitment. This fee is paid whether or not the fund calls the capital or invests using that capital. Some funds charge on invested capital rather than committed capital, but many firms argue that this encourages managers to enter less beneficial deals purely to earn a higher fee.

The typical management fee is 2%, but many funds charge less as an incentive to potential Limited Partners to invest. There are usually discounts for certain limited partners, for example, those who commit particularly large amounts to the fund or those who subscribe during the initial closing period.

Deal sourcing and portfolio construction (GP and companies). This follows on directly from the development of a deal pipeline and is the most active period in the fund’s life. In line with the fund’s predetermined strategy, the General Partner sources potential investments and carries out due diligence, negotiates term sheets with target companies and closes deals. To make the investments, the General Partner will “call” capital from Limited Partners (see below).

Capital calls (GP and LP). Once a deal has closed, the General Partner will contact the Limited Partners - in writing - requesting that they pay a specified amount (up to their committed capital) to the General Partner within a specific time period (usually 7-10 days). As such, the first part of the investment period is also referred to as the “commitment period”, the expected length of which is stated in the fund’s offering materials. Capital calls are also known as “drawdowns”.

Value creation (GP and companies). The main goal of a private equity firm is to exit an investment at the highest possible value (or “exit multiple” - see “Key Metrics below). During the holding period (the time between making and liquidating an investment) the General Partner takes an active role in adding value for the company. Depending on the strategy of the fund, this value creation can take various forms and levels of involvement. Common initiatives include:

Operational transformation. In modern private equity, this is where the majority of company value is created, with larger firms running dedicated value creation teams that carry out a range of initiatives. Top-line growth can be improved by developing new products, expanding to new markets or carrying out digital transformation. Margin expansion is also a common tactic and might be achieved by reducing operating costs through restructuring to increase efficiency and divesting non-core assets.

Team development. It’s very common to private equity firms not just to help steer a company in the right direction with board seats, but to make new management hires. At the lower levels, investment might be made in training and upskilling programs as well as more hiring efforts - especially if there is restructuring taking place.

Buy-and-build. This refers to the strategy of buying a “platform” company with the intention of making multiple acquisitions as “add-ons” to the entire platform. Properly executed buy-and-build strategies add a huge amount of value by expanding scale - both horizontally and vertically - meaning that the final platform company valuation can be far greater than the sum of its parts.

Multiple expansion. There are many ways to increase the exit multiple of an investment besides growing the fundamental value of a company in the examples above. Since the market perception of a company defines how it will be valued on exit, multiple expansion is about improving that perception. This can be achieved by simply clarifying and communicating a company’s growth narrative or taking steps to lower its risk profile.

Deleveraging. By improving the cash flow of a portfolio company and paying down debt, the liabilities on a portfolio company’s balance sheet decrease, increasing the company value over time. In the early decades of private equity, this generated the majority of added value, but it is far less of a value driver in modern deals.

3. Harvesting

Once the investment period is over, the General Partner mostly shifts focus from making new deals to growing existing investments and exiting based on the fund’s strategy. This is a less intensive period of the fund’s life, meaning that management fees are often reduced during this phase. It is also common for a private equity firm to open the next fund

Follow-on investments (GP and companies). Often portfolio companies will require further capital beyond the initial investment. This is especially common for early stage companies going through funding rounds, seeking enough capital to reach certain milestones before the next round begins. Funds take this into account and set aside capital for follow-on investments, to avoid the potential ownership and value dilution if the company were to find funding elsewhere.

Dividend recapitalisations (GP, LPs, companies). This is where the General Partner will require a company to raise debt in order to pay a special dividend to shareholders - meaning the fund itself. The result is that the fund can recoup part (or all) of the equity investment without exiting, making this a common technique for buyout funds.

Exiting investments (GP and companies). The goal of an exit is to reap the highest return possible for the fund and the General Partner will always have clear exit strategies laid out before the investment is made, in line with the predetermined strategy of the fund. Common exit strategies include:

Initial Public Offering (IPO). Also known as “going public”, this is where private equity becomes public equity. From the General Partner’s perspective, an IPO is not a “full” exit, since stakes are generally sold to institutional investors before making shares available to the public, at which point the General Partner will liquidate the remaining shares. The IPO process is complex and costly, with stringent reporting obligations, but when it is properly executed and timed correctly, it can bring a return for the fund that is generally higher than other strategies.

Strategic sale. The General Partner sells the stake in the company to a strategic buyer, usually a large platform company. For example, if the fund has nurtured and developed a small technology company, they might exit through a strategic sale to a large communications conglomerate looking to acquire the technology or enter new markets.

Secondary buyout. This is similar in nature to a strategic sale, but the buyer is another private equity fund. This is common for investments that have not reached the level of maturity required to IPO or make a strategy sale, and it is entirely possible that the purchasing fund is a later-vintage fund managed by the same firm. For example, Fund VIII may “sell” the company to Fund IX to continue growing the investment.

Cash flows and distributions (GP and LPs). Once the General Partner starts to exit investments - or carries out dividend recapitalisations (see above) - cash will start to enter the fund. This is distributed in a “ waterfall”, where distributions are completed at each step before moving on to the next. This is usually customised to the fund but generally has four tiers: 

  1. Return of capital (LPs). Distributions are returned to Limited Partners until they have recouped the full amount that they contributed to the fund.
  2. Preferred return (LPs). The next step returns distributions to Limited Partners until they receive “preferred return” stated in offering materials (usually 8%, but it varies).
  3. Catch-up and carried interest (GP). Distributions go to the General Partner until they have “caught up” with their predetermined percentage of carried interest. For the industry standard of 20% carried interest, the General Partner receives all distributions at this step until profits are split 20% to the General Partner and 80% to the Limited Partners. All future distributions continue with this 20/80 split.

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American vs European Waterfall distributions

American Waterfall. The distribution schedule is applied on a deal-by-deal basis. This means that only the proportion of Limited Partner commitments and preferred return allocated to that specific deal must be returned to Limited Partners before the General Partner receives distributions. The General Partner benefits here, as they start to receive a return before Limited Partners are fully compensated for their contribution.

European Waterfall. The distribution schedule is applied on an aggregate fund basis. This means that Limited Partners must receive their full contribution and preferred return before General Partners begin to receive any profit. Limited Partners benefit here, while the General Partner may not see returns until late in the fund’s life.

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Extension (GPs, LPs, companies). Funds will almost always have optional extensions built into their contracts, usually two or three years. These extension years are added to the fund’s life if the General Partner feels they are needed to harvest the full potential of investments. For example, if companies have grown at a slower rate than expected but are still on track to IPO or gain significant value within a year or two, the fund might make extensions to take advantage of the expected jump in exit valuation.

Fund close (GP). At the end of the fund’s life - whether it has been extended or not - all remaining investments must be liquidated and distributions made following the above schedule.

Additional Limited Partner considerations

Put together, the unique life cycle of a private equity fund creates a particular set of characteristics for each Limited Partner, which we covered in What is private equity and Why invest in private equity. Two considerations might be familiar as the most important elements for any investment entering a portfolio: the return profile and how it affects diversification. 

  1. Return profile (the J-Curve)

As described above, a Limited Partner will commit capital to a fund at the start of its life, then start paying capital into the fund as cash. At this point, the return on the Limited Partner’s investment drops below zero as the General Partner puts the cash to work.

It is not until the fund begins exiting investments during the harvesting period that the fund will start to return cash in the form of distributions, bringing Limited Partners’ return above zero and - if the investments are successful - rising to a beneficial level. Then, as the harvesting period slows and all distributions are made, the return levels out as the fund’s life ends.

The shape of the return profile experienced by the investor is known as the “J-Curve”.

From the Limited Partner perspective, a flatter J-Curve is better. This can be achieved with smaller, more gradual capital calls and faster distributions from those investments. Simply put, it keeps more cash available in the Limited Partner’s wider portfolio to put to use elsewhere. 

You can read more about the J-Curve in our Moonfare White Paper here.

  1. Portfolio diversification

The lock-in period of a private equity fund and J-Curve return profile can create both opportunities and issues for investors looking to maintain a dynamic portfolio - one that is flexible to their changing needs and can be adapted to unexpected events.

On the one hand, the cycle of capital calls and distributions can create a self-funding portfolio where profits from one private equity investment are reinvested in the capital calls of another. This is especially possible if the fund has a particularly flat J-Curve (see above). 

On the other hand, if a private equity fund investment does not return cash until late in the life cycle, Limited Partners can suffer from the illiquid nature of the asset class. Even if a fund generates an excellent return by the end of its lifetime, investors might find themselves in urgent need for liquidity - to fund capital calls, pay debts or any other need for cash. This is where the secondary market comes into play.

The Secondary market

The private equity secondary market refers to the buying and selling of commitments to private equity commitments during a fund’s lifetime. To avoid confusion, when making reference to both private equity secondaries and direct investments into private equity funds (as we have covered throughout this guide), these direct investments are often known as “primary” private equity.

The private equity secondary market has grown steadily since the turn of the century as the benefits have become hard to ignore. These include access to liquidity, a faster return profile and the ability to mitigate Blind Pool risk - see below for more on each of these.

Past performance is not indicative of future performance. 1Jefferies estimates that 2021 secondary volume will be $90.0-100.0 billion.Source: Data provided by Jefferies as of January 2021. https://www.commonfund.org/research-center/articles/secondaries-2021-a-buyers-market

Types of secondary transaction

“LP secondary” transactions. 

This is the most common secondary transaction. It involves an existing Limited Partner that sells its assets to a secondary buyer. The buyer without prior investment in the fund then replaces the Limited Partner with all their rights and obligations.

“GP-led” transactions. The most popular type of GP-led transaction is the ‘continuation vehicle transaction’, taking place when a General Partner needs to extend the investment period of a fund that has reached the end of its life. Portfolio companies (or a single asset) are moved to a new fund vehicle that enables additional follow-on capacity and, hence, extended hold periods. Existing Limited Partners have the option to either ‘roll-over’ or cash out the interest to a secondary buyer. This is also known as “fund recapitalisation”.

Direct secondary transactions. This is the trade of directly-held ownership interest in a company from Limited Partners to an existing investor. A direct secondary transaction is an opportunity to sell stock before the entire portfolio of companies has been sold.

Benefits of secondaries

Liquidity access. For sellers, secondaries can offer a valuable mechanism to better manage otherwise illiquid private equity portfolios. Selling stakes creates a stream of cash that is ready to be deployed into potentially new investment priorities - or satisfy an urgent need for capital.

Faster returns (J-Curve mitigation).

For buyers, investing in a private equity fund secondary as opposed to a primary investment in a fund cuts down the time until cash is returned to Limited Partners. This will - of course - be reflected in the purchase price: the shorter the period until it starts returning capital, the more expensive (and vice versa). 

Mitigating Blind Pool Risk. “Blind Pool Risk” refers to the fact that  Limited Partners commit capital to a portfolio that is yet to be constructed, creating a “blind pool” of capital. In the case of secondaries - especially those purchased late in a fund’s lifetime - investors are putting their money into companies that are already known, allowing them to analyse the performance so far and calculate the future value potential of the underlying companies.

For more on how to access the private equity secondary market, visit the Moonfare Secondary Marketplace. Though liquidity is not guaranteed, Moonfare’s semi-annual digital secondary market is a structured auction that allows investors seeking early liquidity a chance to sell their Moonfare allocations to other members.

What is a secondaries fund?

It is important to make a distinction between the market for private equity fund secondaries (as described above) and a secondaries fund. In the case of a secondaries fund, the fund manager creates a portfolio of private equity fund secondaries, either by buying out other investors or investing capital into funds after they launch.

Investing in a secondaries fund has a number of key benefits:

  • Diversification. Investors in secondaries funds receive access to hundreds of underlying portfolio investments, managed by a General Partner with particular expertise and experience in the field.
  • Lower fees. Investors in secondaries funds typically pay lower fees than “primary” funds. The logic here is that the General Partner role is more as a portfolio manager as opposed to actively adding value to the underlying companies.
  • Early liquidity profile. A secondaries fund invests in underlying funds of various vintages, a strategy designed to offset commitments and distributions against each other. The result is early liquidity and a far shallower J-Curve.

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Important Information: Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections are not guaranteed and may not reflect actual future performance. Your capital is at risk. Please see https://www.moonfare.com/disclaimers

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