How does an investment in a Private Equity fund work ?

So, what is so special about these investments and why does everyone tell me that investing in them requires more patience than buying a mutual fund from my bank ? Because generally, a PE fund is a closed vehicle. This applies to all investment strategies and geographies, primarily because PE invests in private companies.

You cannot just buy a private company like you buy shares in a public one. In general, investing in a private company is a project that lasts three months at least. You need to convince the sellers (or co-shareholders) and management team, you need to agree on a valuation, you have to do the due diligence to ascertain that what you have been told is accurate (investors in public equities are protected by a large set of rules and laws, while in PE, it is much more vague, and usually nothing except willful misconduct is admissible in Court), then you need to confirm (or renegotiate) your valuation, and then you need to execute the transaction, which involves often third parties (banks to finance, lawyers to draft the contracts, other stakeholders to approve them and public bodies to approve anti-trust issues or even strategic preemption rights). In short, if a PE deal falls through, it means you’ve lost three months of your life. Harsh, isn’t it?

And then you need to count that in order to dilute the risk of the fund, you need to invest at least in 15 to 20 companies, sometimes more if you are in more early-stage strategies. But we are getting ahead of ourselves... Back to the beginning...

A PE fund is a number of investors that take the commitment to invest individually an amount X in a fund that is to managed by a management company that is made up of the team that the investor trusts the money with. Such a fund can be incorporated in various countries, but the main hubs on a global level are some states in the US, Luxembourg, the Channel Islands, and some others, quite marginal. The sum of all commitments makes up the size of the fund. The number of investors can vary significantly, mostly also depending on the size of the fund. Once the fund is raised, it's amount is fixed and definite, but you don't invest immediately. You have to wait until the first investment opportunity is won by the team. They will then send a capital call and call x% of your commitment. The amount is usually low, because since they invest your fund in at least 15 deals, it is usually lower than 5%... And they have between 3 and 5 years (depending on the strategy) to invest 100% of your commitment. So even if you are prepared to commit € 1m to a fund, you will only be invested after 3 to 5 years. Needless to say that you need to make sure to not use the money dedicated to the fund because the last Ferrari tempts you, because you do not want to default on your commitment. There are punitive clauses that protect the fund on defaulting investors (a sufficiently rare case that we need not get into it). In the meantime, the fund also periodically calls a portion of your commitment to fund the fees (between 1%-2% of your total commitment per annum during the first years - the investment period- and then the same rate but only on the money still invested, i.e. reduced by the cost of investments that were sold since inception).

Once the fund has invested in 10-12 companies, i.e. has deployed 70-75% of its total commitments, the team usually calls you up to see whether you want to invest in their next fund (or vintage). Usually, raising a fund takes between 6 months (if the economy is great, and the team is very successful) to 2 years (with less of the two). In order to not run out of capital, the team needs to make sure that it still has "dry powder". It will deploy in priority the 25-30% left of the previous fund, but it needs to make sure not to lose investment opportunities because it has run out of investable funds. As such, for each strategy, a successful team usually has three funds alive : the oldest in liquidation phase, the current one which is invested and in "harvesting mode" and a new one waiting to be deployed.

Once the Fund enters into harvesting mode, the team tries to sell its portfolio companies. But there again, it takes 3-6 months (prepare the company, seek buyers, and go through the whole process you underwent when you bought the company). And usually this cannot be done for all companies at the same time. First, because the team usually does not have sufficient resources to organise more than 2 to 3 exits at the same time, but also because the portfolio was built over a period of 3-5 years, and all companies are hence not at the same development stage, and the more recent ones still need some time to execute the strategy that the team has decided for them. **That is why a PE funds usually last between 10 and 12 years. And you need to be patient to recoup your investment.

We will delve into the consequences that such organisation has for the investors and their cash flows in the next post (spoiler : we will introduce the famous "J-Curve"). For the moment, let's stick to some other characteristics of a PE fund :

Remember we spoke about aligning interests ? This is important between the fund and the target company, but they walk the talk and hence the investment team aligns its interests with the investors, via the famous carried interest. In summary, once the fund has returned its initial investments (via the successive exits of the portfolio companies), and has served a preferred interest (between 6% and 10% per annum, depending on the negotiation between the team and investors), the capital gains are split according to the 80/20 method : 20% of all capital gains made go to the team.

We spoke about the management fees earlier on. But such fees usually only pay the yearly salaries (and good bonuses, I admit) and running costs (such running costs can be hefty because you invest due diligence costs in a deal that might not go through. You can theoretically charge such costs to the fund, but that weighs heavily on the performance). In reality, a member of a PE team becomes rich when the team realises capital gains. The term "realises" is important. You don't make money when you make a deal. You make money when you sell said deal with a capital gain, 4-6 years down the road.

So, after 4 to 6 years, the fund starts returning money, according to a waterfall as follows :

• First, all proceeds go to the investor, until the entire amount of the investments at cost is reimbursed - but not your fees, there is no free lunch ;-)

• Then the fund computes the amount of hurdle that is to be paid to the investors. If the hurdle rate is at 8%, the amount of the hurdle is computed at such rate (per annum, so it compounds quickly!) taking into account the dates at which the investors have honored the capital calls, i.e. invested the funds.

• Once the hurdle is reimbursed, there is a catch-up for the team. Indeed, the hurdle is only an "up-front" payment, granting the investor that if things were to not perform as well as anticipated, he has a better chance to make money than the team. This is where interests are more aligned for the investor... In times of crises, it happens that the team works for its salaries only, because it will never redeem the hurdle and see the carried. Especially in funds that have had difficulties to deploy, or which were hit by a crisis while harvesting, and hence have taken too long to redeem investors.

• But if all goes well, after the hurdle, the team receives more than 20% of the next proceeds. There again, depending on the negotiations at the beginning, the team might get 100% of all proceeds until it has obtained 20% of the hurdle, or it only gets a bigger share of proceeds, but the investors still receive money from the next exits... Good teams usually catch-up at 100% on the next exit.

• After all this, proceeds are split 80/20. The 20% going to the team are usually defined at the out-start of the Fund. Partners, who most of the time generate most of the value (they generate the deals, and they have the grey hair and the scars to know how to react in times of difficulties) get a significant portion. But good investors make sure that the younger generation (PE is a long term game, remember, even only during one fund) gets a portion that keeps them pedaling.

Hence, if you are serious about investing in PE, it means that your cash-flows will be negative for quite some time, and any investor needs to take this into account. Indeed, proceeds take some time to come, and usually when a fund enters into "harvesting mode", it raises a new one that will be deployed. Hence, your first cash receipts will cover capital calls from the next vintage. Therefore it is adamant that you pilot your cash flows cautiously (more in the next post) !

In summary, here are a few key take-aways :

• PE is a long-term play. You do not invest on Day One, and returns take time.

• Hence, you need to carefully evaluate the amounts you can invest, and you need to be able to lose them, or wait for their return for a long time (remember, this is a very risky asset class).

• You need to be prepared to first hear bad news. Not only do the fees weigh on valuations (usually your investment starts to lose money, because you pay, partially, for fees), but also, from experience, bad investments are identified much quicker than winners ! If you invest in a good and transparent team, it will not withhold information, and hence, bad news come before good news !

• If you have the ability to invest in PE, it means that you have had some success and were able to generate savings in your professional life. When you invest in PE, you will lose all your marks, because you have no grasp at all on things : you don't get a say on the deals done, you get a quarterly reporting (sometimes only three times a year), and you might be lucky to speak to some members of the investment team once a year. More importantly, you might think that it is time to sell a business (also because you want to see the color of the money), but you get no say at all !

• Eventually, as already explained in the first series of posts, valuation depends on the team and needs to be taken with a grain of salt (positively of negatively). So you don't really know what your investment is worth until it is sold. Not a very comfortable position !

In summary, you need to invest money you don't need, and have faith : in the team, it's track record, it's performance, and in the fact that they will do everything to make your investment a success. But you have no way to interfere in their decisions ! And this will last for more than 10 years...

We hope you have found this (long) post interesting. Please give feedback here or write to contact@korafin.com !