A private equity (PE) fund – a closed-end fund – is an alternative investment asset class. As PE firms are private, the public exchange does not list their capital. They allow high net-worth individuals and institutions to invest and own equity in them. A secondary fund of funds is an investment vehicle used by alternative portfolio managers, including hedge funds and PE professionals. To understand them better, it would be helpful to understand the PE fund structure.
PE funds are closed-end investment assets with a limited window for raising funds. Once the window expires, investors cannot raise more funds. Funds are often formed as an limited liability company or an LP (limited partnership). One significant advantage is that in the event of a crisis, such as a lawsuit or bankruptcy, investors lose only the capital they invested.
Raising a PE fund requires the following:
- Financial sponsors: Individuals who identify, manage and execute investments in private operating businesses. They generally comprise a general partner and a management company. The general partner is legally authorised to make decisions on behalf of the fund and assume legal liabilities. The management company employs investment experts to allocate capital and manage investments.
- Investors: These individuals provide the capital required for PE investments. Funds are LPs, so investors are limited partners. To raise funds, the founders of secondary fund of funds reach out to institutional capital such as university endowments, pension plans and high-net-worth individuals and offices. A capital commitment is made via an agreement stating the quantum of capital to be invested and assets to be returned within a fixed period. The LP agreement often includes the following:
- Fund term: The time horizon set for divestment and investment
- Mandate: Restrictions including geography, security type and scale for acceptable investments
- Fee: Fee to be paid, calculated on the basis of AuM and capital raised
- Distribution waterfall: Economic relationship between LP and GP (The GP earns a carried interest, which is a percentage of the proceeds after LP distributions.)
How do PE firms work?
PE firms raise money from accredited and institutional investors that invest in different asset types. The most popular PE funding types include:
Fund of funds: This funding focuses on investments in funds such as hedge funds and mutual funds. They are often meant for investors lacking minimum capital requirements.
Distressed funds: Also called vulture financing, investors invest in troubled businesses with underperforming assets and units. The primary goal is to restructure their operations and rejig management to bring them back to trade or sell their assets for profit.
Leveraged buyouts: In this form of PE funding, investors buy a company entirely to improve its business and finances. Finally, they resell it at a profit or conduct an IPO. A PE firm spots a target company and arranges the required funding. Most firms mix equity and debt to fund such transactions. They often transfer the debt to the acquired business’s balance sheet to avail of tax benefits.
Venture capital: In venture capital funding, investors provide funds to entrepreneurs in several forms, which is a function of the funding stage: accelerator, early, expansion or late stage.
Real estate PE: Typical funding areas are real estate investment trusts and commercial real estate. They require higher capital compared to other PE categories. In addition, investors’ funds are locked for several years in this type of PE funding.
Payout and Investment Structure
The cost of business and returns on investment are the most significant components of an LPA. It outlines the fund’s management fee for general partners. PE funds use a percentage of the invested capital as an annual fee to pay salaries, legal services and deal sources. Other variables and fixed costs include marketing, research and data expenses. PE companies also receive carry – a performance fee computed as a percentage of the excess gross gain. Investors pay these charges for the fund’s ability to manage issues and mitigate risks.PE firms offer lucrative investment opportunities to institutional and high-net-worth investors. Since a secondary fund of funds is more diversified than a regular PE fund, potential investors must first understand the latter’s structure to be aware of the liabilities involved, performance fees, management expenses and the amount and money to be invested.