Private Equity Funds: A Brief Introduction

Private equity funds act as an intermediary between institutional investors and high-net-worth individuals on one side and privately held companies that are seeking capital to finance crucial stages of their corporate activity on the other. Private equity funds are collective investment schemes that gather the capital of a number of investors to invest in from ten to thirty companies. A management team (typically called the general partner) deploys the capital provided by the investors (called the limited partners) according to a predefined investment strategy. Investors do not typically take part in the day-to-day management of the fund, and their liability to the financial exposure of the fund is limited to their capital commitment made to the fund.

The risk profile of investments in private equity varies greatly: individual direct investments in privately held companies are the riskiest. Structured products such as hedge funds or securitization notes allow risk to be tailored to individual investors’ needs.

Funds are a good way to diversify risks associated with investments in privately held companies, and diversification benefits increase with the number of fund investments held by an investor. Fund-of-fund investments have a risk profile comparable to holding a diversified portfolio of fund investments individually.

Private equity is an asset class that promises high returns for taking high risks. Private equity might even outperform other asset classes on a purely risk-adjusted basis, since the inefficiencies of private equity markets allow the investors to benefit from information asymmetry, legally obtained insider information, and the superior investment skills of individual managers. These elements are typically not relevant for public market investments, where information is generally shared and reflected in market prices and where residual minor market inefficiencies are difficult to exploit through arbitrage because of the transaction costs.

However, the higher return opportunities in private equity come at a price. In addition to relatively high management cost, investors in this asset class need to accept low liquidity for their investment and long holding periods before returns may materialize. Investments in individual companies typically have a holding period of between three to five years, fund investments have a lifetime of eight to twelve years, and fund-of-fund investments can last up to fifteen years before being divested. Also, investors in private equity—no matter at what level—need superior selection skills in their investment managers; the quality of fund managers varies greatly and the natural selection of successful teams through investment performance is slow.

Private equity funds can target a wide range of segments of private equity. Typical segments include:

• Seed financing in the creation stage of companies
• Start-up capital for companies developing prototypes of a marketable product
• Expansion capital for market penetration
• Buy-out capital and replacement capital for dealing with changing ownership structures in companies and succession issues
• Pre-IPO financing to prepare companies for public listing
• Turnaround capital to support distressed companies in the restructuring of their business activities
• Mezzanine capital as an instrument to leverage equity investments in buy-out or development financing

Risk profiles of these segments differ and so does the skill set required of managers investing in the various segments. For example, investment assessment in early-stage technology companies requires a deep understanding of the technology risk and the market potential of the product.  Market risks and product risks are typically less pronounced in late-stage companies or in buy-out situations. In these stages it is often the superior financial structuring and organizational development skills of the fund manager that make the difference in a successful investment.