What is a Private Equity Fund?

Private equity funds are pools of capital invested in private companies (not listed/traded on an exchange) with the objective of achieving a high rate of return. These funds pool money from institutional investors, sovereign wealth funds, and high net worth individuals, while ordinary retail investors are precluded from participation. The investment horizon for these vehicles can vary, but most often it ranges between five and ten years. At the end of this horizon, the manager will seek to exit the investment, typically through an initial public offering (IPO) or sale to another company. Should an IPO be the preferred route, anywhere from 25% to 50% of equity will be made available while the fund retains the remaining stake? Over time, the private equity fund will exit the remaining investment.

Key Learning Points

  • Private equity funds are collective investment vehicles, just like mutual funds, but are available only to institutional investors like sovereign wealth and pension funds, insurance companies, hedge funds, family offices, endowments, and high net worth.
  • They invest in companies that are private, meaning they are not listed on an exchange, with the objective of earning a high return on exiting the investment. Private equity funds are considered to carry significant risk.
  • Private equity funds have a medium to long-term investment horizon. Typical exit strategies include initial public offerings, leveraged buyouts (LBO), or sale to another company.
  • Private equity is categorized as an alternative asset class with low correlation to the broader market and can be used to diversify a core portfolio.

Different Types of Private Equity Funds

 Different Types of Private Equity Funds

Venture Capital (VC)

Venture capital funds invest in companies that are at an early stage of development. Target companies for investment are expected to have significant growth potential but limited access to funding. The typical profile is an ambitious start-up with a niche in the market and an ability to offer something to compete with established peers (for example an innovation or technological discovery). Venture capital funds do not carry debt and have the potential to generate high rates of return based on the rigor of their investment process. However, the risk of investing in small companies with almost no track record is also very high.

Buyout or Leveraged Buyout (LBO)

Buyout or Leveraged Buyout funds invest in more mature businesses and generally seek to acquire a controlling stake. They use extensive leverage to achieve a higher rate of return. In an LBO, one company takes on a significant amount of debt to acquire another. Once the controlling company creates significant value in the business, it pursues a gradual exit strategy.

Growth Capital (GC)

Growth Capital private equity funds invest in already established businesses that are larger in size and have functioning operations and infrastructure. The investment makes it possible to restructure their operating model, gain access to new markets and industries, or fund a potential acquisition. Typically, the amount invested is relatively small since these companies have solid earnings and are profitable, but cannot afford to use existing assets to obtain financing.

Real Estate

Real Estate private equity funds require larger investments relative to the other types of private equity. They seek to own multiple properties and use different investment strategies. For example, lower-risk options invest in properties where future cash flows are highly predictable. In contrast, higher risk strategies offer the potential for higher returns but invest in properties that need significant enhancement or build from scratch – for example, they may invest in land for development.

Fund of Funds (FoF)

A fund of private equity funds does not invest directly in private companies but rather in other private equity managers. The advantage of this approach is diversification of risk as the portfolio is spread across multiple investment strategies. However, these funds are not expected to deliver returns as high as those which invest directly in unlisted companies.

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How Do Private Equity Funds Work?

Private equity funds are typically structured to include limited partners (LPs) and general partners (GPs). Investors who inject capital into the vehicle are limited partners while the professional investors who manage the fund and make decisions are general partners. The responsibilities of general partners include selecting investments and building a portfolio, structuring deals, monitoring investments, and crafting an exit strategy.

Private equity is a growing market and is crucial to the economic system since it provides financing and facilitates the growth of many small and mid-sized businesses. The majority of “unicorns” (a start-up company that has reached a valuation of $1bn) have received funding through private equity funds.

Another notable difference between mutual funds and listed companies is reporting. Since private equity funds invest in private companies, they are not subject to the same reporting standards as listed entities. For that reason, they are often viewed as less transparent and it is more difficult to obtain current and comprehensive information about the fund.

Some of the largest private equity managers include Blackstone, Kohlberg Kravis Roberts & Co. (KKR), and The Carlyle Group.

Private Equity Fund Vs. Hedge Fund

Although both private equity and hedge funds are considered alternative investments and seek to attract capital from sophisticated investors, there are some notable differences between the two. For example, hedge funds may assume higher risk and invest in more complex instruments (including derivatives) with the objective of achieving high returns. Hedge funds also have shorter lock-up periods. While both prevent clients from withdrawing funds for a certain period, private equity funds are less liquid and therefore require longer lock-up periods. This allows the manager to efficiently allocate funds and exit the investment at a profit. Last but not least, most private equity funds are closed-ended, meaning that funds cannot be invested nor shares redeemed after the initial investment period.

Additional Resources

Carried and Promoted Interests

Cov-lite Loans

Debt Structuring in Leveraged Buyouts

Unitranche Debt

Seed Equity