A Primer on Private Equity - Inside story of world's fastest growing fund structure

This article will help you understand the history & fundamentals of Private Equity funds, together with some of the big players.

Introduction

Private equity funds are group of investors and funds that invest money in companies which are not gone public that is the ones which are not listed on any stock exchange. This type of investment is aimed at gaining significant, or even complete, control of a company in the hopes of earning a high return. The investments are made directly into private companies or there can be buyouts of public companies that result in a delisting of public equity. Generally, shares issued are proportional to the amount of the investment so that the person who has invested the majority of the money in effect controls the company.

Who invest in PE??Pension Funds, and other institutional investors, wealthy Individuals that HNW ppl invest in private equity because they want their investments to outperform the public markets.

As I said Majority of private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Why long period of time??Because, Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company. As you can see here are few examples or types of PE.

So the critical features of PE are

History of PE

LBOs established themselves on Wall Street, and in the lexicon of financial terminology, in the late 1970s and 1980s when investment bankers, like notably high-profile financier Michael Milken, created them as a method of leveraging a company with debt equity and equity capital in order to buy it. Among the most infamous LBOs of that period was the $25 billion RJR Nabisco buyout in 1988. In many ways, today’s PE firm is yesterday’s LBO firm.

The private equity industry has enjoyed significant growth since the 1970s. As of June 2015, assets?under management of private equity investments (including private equity, venture capital, private debt, real estate, infrastructure and natural resources) - totalled USD 4,2 trillion according to the private equity research firm Preqin. Trends in fundraising and the number of funds demonstrate the industry’s cyclicality and the indirect impact of credit cycles in debt markets on entry and exit multiples. As a result, the industry has gone through a process of consolidation, and the number of funds has fallen from its 2000 peak of 1,666 funds to 594 in 2015. Traditionally, family offices and university endowments were the main allocators to private equity. However, the risk/return profile of private equity investments has recently attracted non-traditional investors such as sovereign wealth funds.

Successful PEs of world

1.????Apollo Global Management - Apollo was founded in 1990 by Leon Black, formerly of Drexel Burnham Lambert. The company operates globally from its New York headquarters office, with other locations in Los Angeles, London, Frankfurt and Singapore. It specializes in leveraged buyouts and in buying distressed securities. Notable portfolio investments include Norwegian Cruise Line and Caesar's Entertainment Group. It had $150 billion AUM for 2015.

2.????Blackstone Group LP – It was founded in 1985 and is based out of NewYork. It has an AUM of $146 billion. The company invests across a broad range of market sectors, including energy, retail and technology. Its current portfolio includes residential security firm Vivint, Seaworld Parks and Entertainment, and Leica Camera.

3.????Carlyle Group - The Carlyle Group (NASDAQ: CG), with roughly $124 billion in private equity assets, operates through more than 30 offices located in North and South America, Europe, Africa, the Middle East and Asia. The company was founded in 1987 and is headquartered in Washington. Current portfolio holdings include the Bank of N.T. Butterfield & Son Ltd. in Bermuda, CalPeak Power and financial services firm Edgewood Partners Holdings LLC.

4.????KKR & Company LP – It has around $98 billion in PE assets. formerly Kohlberg Kravis Roberts & Company. Founded in 1976 and headquartered in New York, KKR & Company is known for being one of the first firms to engage in large scale leveraged buyouts (LBO), which are still one of the firm's specialties. Among the firm's noteworthy transactions are its 1989 leveraged buyout of RJR Nabisco and its 2007 buyout of TXU, the largest leveraged buyout on record. Among its current portfolio holdings are Alliant Insurance Services and Panasonic Healthcare.

5.????Ares Management LP - The firm currently has private equity assets in excess of $75 billion. Ares operates mainly in the United States and specializes in providing financing for acquisitions. Its current investment portfolio includes Aspen Dental and Neiman Marcus. It is headquartered in LA and has additional offices in London, Hongkong & Shanghai

6.????Oaktree Capital Management LP – It was founded in 1955 . The company has other offices in London, Hong Kong, Paris, Singapore and Seoul. Oaktree specializes in high yield and distressed debt situations, and is the largest distressed debt investor worldwide. With approximately $70 billion in AUM, two of the firm's current focuses are on U.S. commercial real estate and corporate bonds issued in emerging market economies.

7.????Fortress iNvestment Group LLC - Fortress Investment Group (NYSE: FIG), headquartered in New York, has approximately $68 billion in assets spread across its private equity, hedge fund and credit divisions. The company was founded in 1998 and went public in 2007. Among Fortress's varied portfolio companies are RailAmerica, Brookdale Senior Living, Penn National Gaming and Newcastle Investment Corporation.

8.????Bain Capital LLC - Bain Capital, founded in 1984 and headquartered in Boston, is one of the most widely recognized private equity firms worldwide. Bain operates globally with additional offices in London, Hong Kong, Mumbai, Tokyo, Shanghai and Melbourne. The firm currently manages approximately $65 billion in private equity assets. The long list of Bain Capital's acquisitions include such well-known companies as Burger King, Hospital Corporation of America, Staples, the Weather Channel and AMC Theaters. Its current portfolio includes Consolidated Container Company and SquareTrade.

9.????TPG Capital LP - TPG Capital, formerly known as Texas Pacific Group, is headquartered jointly in Fort Worth and San Francisco. TPG also has offices in Europe, Asia and Australia. With approximately $62 billion in assets, TPG Capital specializes in leveraged buyouts and leveraged recapitalization of distressed companies. Current investments include Airbnb and China Renewable Energy.

10.?Ardain -Ardian has approximately $45 billion in private equity assets. The company, founded by Dominique Senequier and headquartered in Paris, has offices in London, Frankfurt, New York and Singapore. Notable portfolio investments include Vinci Park, ESIM Chemicals and NHV Group.

Fees of PE

The fee structure of PE is similar to Hedge funds so just like Hedge funds they charge a management fee & Performance fee.

-???????Management fee

These are paid regularly by limited partners that people who have given money to fund to be invested. This is calculated on % basis and it is % of AUM. For example if AUM is 100bn than a 25 management fee would be $2bn. These fees are utilised for admin purpose and to cover expense such as salaries, deal fees paid to investment banks, consultants, travel exp etc.

-???????Carried Interest

Carried interest is the share of a fund’s net profits allocated to the General Partner. It refers to the General Partner being carried by investors because it receives a share in profits disproportionate to its capital commitment to the fund. It is thus a % of the profits that funds gains on investments. For example if a company is bought for $100bn and sold for $300 billion the profit is $200 billion.?

The PE firm usually takes 20% as performance fee ($40bn) and the rest will go to investor. However, note that there is a Hurdle rate of return that a fund has to make before getting paid this performance fees. For example, the limited partners may ask that the fund only gets paid if the return is over 9% pa. In addition the profit is calculated for the performance as a whole for the whole amount invested that can be 5-10 deals in a year and not on deal to deal basis.

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Remember, The most prevalent fee structure is commonly referred to as a “2 and 20,” whereby a management fee of 2% is charged on assets under management or total committed capital, and a 20% performance fee is assessed on fund profits.

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Equity-Based Carry

Equity-based carry is the traditional concept of carry from the time private equity firms came into being. Interest in a fund is allocated as shares based on each Limited Partner’s capital contribution, with a certain percentage of these shares (typically 20%) allocated to the General Partner as carry. Carry shares usually have a multi-year vesting period that tracks investments made. Equity carry is typically split between senior executives at the private equity firm. Keep in mind there are many flavors of carried interest so doing an apples to apples comparison of two different carry packages is difficult.

Hurdle Rates

Typically, the General Partner only receives carry when the fund generates profits above a certain hurdle rate. That is they would earn only after a specified return is earned. Think of the hurdle rate as a specific internal rate of return (IRR) – an annualized, compounded return rate that Limited Partners must get before the General Partner gets carried interest profits.

Simplistically, a Limited Partner could invest in, say, an equity index that generates a 6% annual return. By investing in a private equity fund, Limited Partners take on higher-than-market risk and want a minimum rate of return (hurdle rate) before sharing profits with the General Partner.

Assume a fund with a 10% hurdle rate and a 20% carry. When the fund makes a profit, it is first allocated so each Limited Partner receives its cumulative IRR of 10% on contributed and un-returned capital. Next, 80% of all remaining profit is allocated to partners (proportional to their respective capital commitments) and 20% is allocated to the General Partner. The General Partner typically has a 100% “catch-up” allocation on carried interest.

Floors

Some funds are structured with a “floor” where carried interest is only allocated on investments where net profits exceed the hurdle rate. There is no General Partner “catch-up” provision, and this approach, not surprisingly, is strongly resisted by General Partners.

Who Keeps Carry?

In reality, very few private equity teams get full dibs on their carry. Retired partners often get a share of carry for a certain period after they retire as part of a buyout of their equity in the firm. Private equity firms that are either spun out, have minority shareholders, or are owned by a parent company, often pay a significant chunk (10% to 50%) of carry to their old or existing owners.?

Escrow and Claw-Back

Many investors demand escrow and “claw-back” arrangements so early over-payments can be returned if the fund underperforms as a whole. Practically speaking, though, claw-backs are difficult to enforce, especially if carry recipients have either left the firm or suffered major financial setbacks such as investing their carry in shares that subsequently collapsed or using carry to pay off a divorce settlement.

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