If you’re considering investing in a private equity firm, these are the most important things to consider.
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1. Private firms differ from mutual funds in a key way
I liken a private equity fund to a mutual fund. A private equity fund, by its very nature and name, is private. It aggregates capital from a number of sources: primarily pension funds, wealthy families, individuals, and companies that have meaningful assets available for investment. Depending on the size of the fund, it is typical for an established firm to have a minimum investment size of $5 million. These funds are then used to purchase companies or buy a stake in a company.
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2. If you invest, you’re a limited partner
People who invest in a private equity fund are called limited partners. Limited partners have no decision-making authority over the private equity firm or the investments made by the fund. The private equity firm serves as the general partner and has total control over the funds’ investments. Limited partners pledge capital for a specified amount of time, generally the life of the fund and thus cannot buy and sell on a whim.
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3. Your investment is a commitment
With private equity funds, there generally is no liquidity, and a private equity fund typically has a charter, or a life span, of ten years. This means you’re committing capital for a period of up to ten years. Keep in mind that it’s typical for funds to have built in, up to two, one-year extensions that don’t require further approval of limited partners, so the money could actually be locked up for as long as twelve years.
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4. Private equity funds issue capital calls
The way a private equity fund starts investing is by issuing capital calls for the money it needs from limited partners. Say you’re an investor in a small private equity fund that is $100 million in size. You commit $1 million to the fund, or 1%. You don’t invest that money up front; rather, you’ve committed the capital. So, if the fund purchases a company and needs $12 million in equity from the fund to complete the purchase, you’ll get a call asking for $120,000, which is 1% of the $12 million of equity needed.
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5. Your capital is returned over time
The return of capital happens over time. Anytime a private equity fund sells a company or refinances for the purpose of creating a distribution, it returns capital to its limited partners. Say the company that was purchased with $12 million in equity from the fund is sold five years later, and after the dust settles, there’s $36 million in equity remaining. As a 1% investor, you would receive $360,000, or 1% of that equity.
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6. Some funds have time limits
In the early years of a new private equity fund, the fund will be buying companies that become platforms for growth and will require further investments during their hold period. These are the anchor holdings of the new fund. Some private equity groups state a time limit in their fund’s limited partnership agreement that essentially says all platforms have to be bought within the first six or seven years.
Others don’t include the time limit; typically, the hold period in private equity for each portfolio company purchased by the fund is three to seven years, with five being a good average for general planning purposes.
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7. Some funds don’t use limited partners
Sometimes private equity funds use captive, proprietary, or family-generated funds and don’t really need limited partners to make investments. Examples include MSD Capital, which is the private “family fund” of Michael S. Dell of Dell computer fame, and OMERS Private Markets, the direct investing arm of the Ontario Municipal Employees Retirement System, which is a self-contained arm of the pension fund that actually does its own investing. These funds are self-investing their own capital, which means they don’t necessarily have to buy and sell within a specific time frame or hold period.
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8. There are reporting requirements
During the fund’s life, there are reporting requirements to the limited partners. Typically, a quarterly financial report is sent out to discuss the funds: where the money has been invested, what capital has been returned, and the current value of invested funds.
Most firms hold an annual meeting with the limited partners of a specific fund, especially if it’s a large private equity shop that has multiple funds ongoing. The firm gets the limited partners together and presents information about the companies that have been purchased and sold by the fund. They may even bring in some CEOs to speak and/or answer questions about individual portfolio companies.
Adam Coffey has spent the last 18 years as president and CEO of three national service companies, all of which were sold to private equity firms. He is the author of The Private Equity Playbook. This article is an excerpt from his book.
This article originally appeared on and was syndicated by MediaFeed.org.
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