Private Equity Funds
Medium-sized and large corporations can generally turn to the financial markets for financing and loans. They can also borrow readily from banks. Small businesses, on the other hand, have greater difficulty in obtaining financing. If the business is in financial distress, then even a large business will have difficulty getting financing. A private equity firm looks for businesses that could be very profitable but are financially distressed because of mismanagement, with the hope of salvaging these businesses that would otherwise become insolvent or go bankrupt.
A private equity fund generally seeks high returns to compensate it for the risk that it takes, since the fund invests in businesses that have a high probability of failure. After all, if a business were sound, then it would not need a private equity infusion, since it would easily be able to obtain bank loans or other sources of financing.
A private equity fund is generally structured as a limited partnership that invests in the business by buying its stock or preferred stock that is convertible to the common stock and that is not traded in the general market, which is why it is referred to as private equity. If the business is unincorporated, then the private equity firm will incorporate the business and install at least some of its representatives on the Board of Directors.
Although most people do not invest directly in private equity funds, many are affected by private equity returns, since most pension funds invest some of their money into private equity. As of June 30, 2013, private equity assets approached $3.5 trillion.
Private Equity as an Investment
Because of the risk and because private equity funds do not want to register with the Securities and Exchange Commission (SEC), private equity funds are primarily marketed to accredited investors, those with a net worth of at least $1 million, excluding the primary residence, or who earn at least $200,000 annually, and to institutional investors and pension funds.
A private equity fund differs from hedge funds and mutual funds primarily by investing in most or all of the stock of a few businesses, so that it has virtually complete control. Without diversification, the private equity firm needs greater control so that profits are more certain. In such a situation, the original business owner must cede control to the private equity firm.
After buying a stake in the company, the private equity firm places some of its members on the board of directors, then arranges the financing to purchase the public stock. In most cases, the financing is achieved by borrowing heavily, in what is called a leveraged buyout. However, if the company cannot repay the debt, as often happens, then the investors in the private equity fund may lose most or all of their investment.
Private equity funds generally have terms of 10 years that may possibly be extended to 3 more years, but the firm's investment in an individual business is usually held for 4 to 7 years, with investments in different businesses staggered over the duration of the fund. Investments are long-term so that the private equity firm has enough time to, hopefully, turn the business around. The private equity firm must think that the business has significant growth opportunities that can be realized with better management; otherwise, the business would not be able to grow, making it difficult either to service the debt that is often used to buy the business interest or for the private equity firm to profit from its exit strategy.
A stockholder who buys shares in a corporation can easily sell his shares at any time. Because a private equity firm makes a large investment in the business and because it cannot easily exit the business in the short term, it wants a larger amount of control so that success is more probable. The private equity firm seeks preferential rights through shareholders agreements, such as additional voting rights, priority to receive dividends, and may even negotiate a guaranteed profit. Sometimes the private equity firm will make loans rather than take an equity stake. However, such loans, referred to as mezzanine debt, have a lower priority than bank loans and other senior and even junior debt.
Most private equity funds are organized as limited partnerships, with the private equity firm serving as general partner and the investors of the fund are the limited partners, who provide most of the capital.
Private Placement Memorandum
When forming the fund, the firm must 1st determine the business objective, the fee structure, and governance. A private placement memorandum (PPM) provides the necessary information for private investors to make a decision about the investment, including information about the general partner, his capital contribution, and the capital contribution expected from the limited partners.
Investments in a private equity fund are different from most other investments. There is an initial minimum contribution, called a capital subscription. Afterwards, the fund will issue calls for additional capital for which the investors have already committed to. The total amount of the commitment is referred to as committed capital. The PPM will generally list a capital call policy that outlines the manner in which additional capital will be requested. For instance, the capital call policy may require that the installment be paid within 30 days of the call notice, that each call notice will not be greater than 25% of the total capital commitment, and that the total capital commitment will be required within the 1st 5 years of the fund. The total amount already paid is referred to as the paid-in capital. The vintage year is the year in which capital is 1st drawn down.
The PPM also lists the number of private companies that will be included in the fund, usually 15 to 18. The fund hopes to earn a return of 50 to 70% for at least 1 out of 10 companies — what is sometimes called the venture utopia firm. Another 4 out of the 10 companies are expected to survive but not thrive, and they are sometimes referred to as the living dead. Half of the companies are expected to fail and are referred to, appropriately enough, as black hole investments. Overall, a typical private equity fund hopes to achieve a 25 to 25% annualized return, a return high enough to compensate the investors for the higher risk.
The PPM also states the amount of capital that will be required to meet the funds objective. Once met, then the firm starts looking for businesses to invest in, screening companies for growth potential so that its expectations of higher returns have a possibility of being achieved. After narrowing the possibilities, the firm then performs due diligence on the most promising companies. The firm will also borrow money for additional leverage, to increase the potential return on investment. If the firm invests in the business by taking an equity stake, then it receives either stock or preferred stock that can be converted into common stock for its investment.
Method of Operation
Private equity firms have 3 primary strategies of earning a profit: to fund business startups, to increase the growth of mature businesses, or to take financially distressed public companies private in the hope of reorganizing it into a viable business that can be sold privately or in an initial public offering (IPO).
The terms of the private equity stake are specified in the term sheet, which also lists the assessed present value of the business, which will be used to market the fund to outside investors. The term sheet summarizes the principal provisions of a potential investment, used in the negotiation process as the business owners and private equity firm strive toward an agreement. Generally, companies are evaluated using discounted cash flows (DCF), discounting the expected cash flow by the fund's required rate of return. A major consideration is that the company has sufficient liquidity to service debt, since a major portion of the cash infusion is from borrowed money.
To be included in a private equity fund, an unincorporated business must become a C corporation, or more rarely, a limited liability company. The firm designates 1 or more representatives to sit on the board of directors, usually as the chairperson. The owners and management team that were in place before the takeover continue to manage the company, but the private equity firm, through its control of the board of directors, governs according to its overall objectives and strategy. Because good management is the most important factor in determining the success of the business, the private equity firm will often recruit additional talent.
A private business has few disclosure requirements. If the business is organized as a corporation or as a limited liability company, then its formation documents must be filed with the Secretary of State under which it is organized. Thereafter, only changes in the corporation charter or bylaws would need to be reported. However, when a business becomes part of a private equity holding, then that must be reported to the Secretary of State. If a business is liquidated through bankruptcy, then the details will become part of the public record.
When a private equity firm invests in a business, it does not pay a lump sum, but spreads the payments out over time, as long as the business can meet certain benchmarks, such as an adequate return on investment. Each payment depends on meeting the benchmarks. The private equity firm will have an exit strategy: either selling the business or its assets or taking the company public through an initial public offering. When considering the sale of assets, the value of tangible assets, such as real estate, are often separately valued from intangible assets, such as patents. However, if the business shows the promise of a strong growth rate, then the private equity firm is more likely to consider an IPO, which can return much higher profits than selling the business as a whole.
Evaluating Private Equity Funds
Potential investors should request a screening criteria or checklist that is used by the general partner to perform due diligence in selecting businesses to invest in. Because the private equity fund manager must manage a real business, it generally takes more experience, so potential investors should inquire as to how many years of experience the manager has had in running an actual business. The potential investor should also decide on what type of fund to invest in:
- venture capital funds,
- growth funds,
- exit stage or buyout funds, which are funds that seek to sell the private business to another business or
- to take the company private.
To sell the limited partnership units, the limited partnership agreement will generally specify a preferred return clause, also known as the hurdle rate, that specifies the minimum return to the limited partners before the general partners receive any portion of the profits: typically around 8% for the internal rate of return.
The manager's compensation agreement will usually have a clawback provision, where a portion of the carried interest earned by the general partner is clawed back because of losses in subsequent investments. For instance, the compensation agreement may provide that if cumulative profits, calculated when the fund ends, results in distributions to the general partner in excess of 20%, then the excess will be returned to the limited partners.
The internal rate of return (IRR) is the interest rate that yields a net present value of zero for cash inflows and outflows assuming that distributions are reinvested at the IRR rate. With respect to private equity returns, IRR measures the limited partnerships annualized IRR based on contributions and distributions, after subtracting fees and profit shares to the general partners. If a fund has not terminated, then the last cash flow is considered the residual net asset value as of the last reporting date. The IRR can be calculated using spreadsheet formulas, such as those found in Excel.
|Year 1 Distribution||$425,000|
|Year 2 Distribution||$475,000|
|Year 3 Distribution||$256,000|
|Year 4 Distribution||$150,000|
|Internal Rate of Return||13.99%|
The IRR function requires a negative number, usually the investment, then positive distributions. (Note that most private equity funds have a term of at least 10 years: the shortened time in the above example is to simplify the calculations.)
There are several additional metrics by which to measure the performance of a private equity fund. The investment multiple of a private equity fund compares the sum of all fund contributions by investors to distributions and the value of any unrealized investments, minus fees and carried interest. The investment multiple is the ratio of the total value of the fund to its paid-in capital, where the total value of the fund is the cash returned to investors and the remaining net asset value. Obviously, a higher investment multiple indicates better performance.
3 other private equity ratios are required to be reported so as to comply with guidelines set by the Global Investment Performance Standards (GIPS), which is an organization that publishes voluntary standards for reporting investment performance, so that funds can be compared worldwide.
The realization multiple shows how much of the funds return has already been paid out to investors:
Realization Multiple (aka Distributions to Paid-in Multiple) = Cumulative Distributions ÷ Paid-in Capital
The residual value to paid-in multiple indicates how much of the funds return depends on the market value of the investments:
Residual Value to Paid-in Multiple = Residual NAV ÷ Paid-in Capital
The paid-in capital multiple (PIC) shows the percentage of committed capital that has been drawn down.
Paid-in Capital Multiple = Paid-In Capital ÷ Committed Capital
Disadvantages to Investing in Private Equity Funds
There are several disadvantages to investing in private equity funds. Because most are organized as private limited partnerships, the LP units cannot easily be sold. Only institutional and accredited investors can buy the LP units and, since they are not marketed to the public, the LP units would be difficult to value. Usually, the LP agreement stipulates that an investor can only withdraw the amount invested after at least 10 years. The agreement may allow the LP to sell his units to the other limited partners or the general partner, but there is no guarantee that they will accept the sale or pay a certain price.
Private equity funds, like hedge funds, have high costs. They usually charge a 2% management fee and a 20% share of profit fee (2-and-20 shop). The 20% fee is treated as carried interest, which is treated as a long-term capital gain that is taxed at lower rates, even though the fee is for providing services that would otherwise be subject to ordinary income taxes and employment taxes. Additionally, many private equity firms use placement agents to sell more LP units to potential investors. These placement agents generally charge 1% of the funds that they raise.
Another major drawback of private equity funds is that the private equity firm will often load the private business with debt – referred to as private recapitalization — to fund payouts to the private equity owners. These dividend deals are a major burden to the private business, which may precipitate its failure.
Private Equity Allows Institutional Theft
The problem with private equity funds is that the interest of the fund's advisers and managers are misaligned with those of the investors. Although overall profits are determined by the success of the fund's investments, advisers and managers can enhance their own profits by reducing the profits allocated to the investors. Recently, examiners from the Office of Compliance Inspections and Examinations (OCIE), who collect information for the SEC commissioners, examined newly registered private equity advisors. This study has shown that between 40% and 60% of all examinations of private equity firms have revealed misallocations of fees and expenses, or by charging hidden fees. Additionally, many private equity funds use valuation techniques to inflate the value of their funds, which are presented in their marketing materials to new investors. They may also use other methods of misrepresentation.
Although many investors conduct due diligence before investing, they rarely monitor those investments afterwards, and, indeed, private equity funds may make it difficult by not providing detailed reports to its investors. Even if most investors do not invest in private equity or hedge funds, many pension funds do, so fraud by private equity advisors diminishes the retirement savings of many people.
Limited partnership agreements broadly characterize fees and expenses, allowing the allocation of fees and expenses that increase the returns for the advisors and lowers the returns for the investors. Disclosures generally do not provide clearly defined evaluation procedures, investment strategies, and protocols for reducing conflicts of interest, including investment allocation.
Fees and Expenses Are Often Inflated, Hidden, or Misallocated
Private equity managers and advisers generally control the businesses that they invest in, as they also control the fund itself. Therefore, there are many opportunities for what I call institutional theft, which often results when insiders have significant control over the operation of the organization and outsiders can do little about it, even if they knew how their interests are being sacrificed to the interests of the insiders. For instance, the advisors can tell the businesses who to hire, who should provide services for the business, and at what cost. Additionally, advisors can allocate their best trades to proprietary funds rather than client funds, and they can allocate expenses to client funds, resulting in more money for them at the expense of their investors. This institutional theft is aided by broadly worded disclosures and inadequate reporting, resulting in poor transparency, so that even investors who want to monitor their investments are limited in their ability to do so.
The problem of portfolio advisors is that the private equity advisor controls the companies in his portfolio, thus it can dictate who to hire as an advisor or an affiliate, or other third-parties, to provide certain services according to the terms of its engagement, including prices paid for services or to instruct the company to pay certain of the advisor's bills or reimburse the advisor for certain expenses, or even to tell the company to hire specific employees. Unable to raise additional capital, zombie advisors or managers continue managing legacy businesses long past their expected lifetime, to generate profits from fees and expenses charged to the investors.
Many private equity firms employ operating partners who are often paid directly by the portfolio companies of the funds without disclosing that to investors. Payments to these professionals constitutes an additional fee not included in the management fee or the carried interest. Oftentimes, the operating partners are presented as employees of the advisor, only to be terminated later, then rehired as consultants, resulting in additional fees charged by the fund. Fees for automatic reporting are often passed to the investors instead of being included as part of the cost of operations.
Accelerated monitoring fees are charged to portfolio companies by advisors in exchange for the advisor providing board and other advisory services during the portfolio companies holding period. Even though most portfolios are not held for longer than 5 years, monitoring fees may last 10 years or longer, and are usually automatically renewed annually. Additionally, the advisor may even collect a fee to terminate the monitoring agreement which the portfolio company had to sign pursuant to the advisor's request. The termination fee equals the acceleration of the monitoring fees for the contract duration, discounted at a risk-free rate.
Other hidden fees include: charging administrative or other fees not disclosed in the limited partnership agreement; charging transaction fees that exceed the limits specified in the limited partnership agreement, but not disclosed, such as recapitalizations; paying parties related to the advisor for services that may have little or no value.
Inflated Valuations and Misrepresentations
Potential investors generally determine whether they want to invest in a private equity fund based on its valuation. However, private equity advisors often use valuation methods that differ from those disclosed to investors. For instance, an internal rate of return may be calculated without deducting fees and expenses, or the value of the underlying funds may simply be inflated. In one instance, the reported gross internal rate of return was reported as 38%, but if fees and expenses were deducted as they should have been, the internal rate of return would have been 3.8%, 1/10th of the reported amount.
Sometimes, valuation methods are changed for the sole purpose of making the investment appear better than it actually is. For instance, the limited partnership agreement may specify that trailing comparables be used to value the portfolio, but later, the advisor may switch to using forward comparables, which must necessarily be based on projections that may be too optimistic. Needless to say, forward projections are usually highly favorable compared to trailing comparables.
Other common misrepresentations include using projected performance instead of actual valuations, but not disclosing that fact, or reporting that specific people will play a role in managing the fund, but who resign shortly after the fundraising is completed.
Actual Private Equity Performance
There were times when private equity outperformed the market by considerable percentages, but, according to some studies, private equity funds performed only marginally better than the S&P 500. During some of the years, private equity funds did worse. Consequently, most private equity funds are not worth the attendant risk, especially considering that they are illiquid investments with a term of at least 10 years.