Private Equity Funds is an investment vehicle that collects money from institution, high net worth individuals or both and invests in various business ventures. The attraction of private equity lies in its long-term substantial gains with investors blocking their money for a certain period usually around 8 to 10 years. The investors get their returns as and when the investments are realized at a rate agreed per the legal documents. There are instances when losses occur, and the investors had to bear the share as well.
The General Partner (GP) has the control over the fund and the structure based on the Memorandum which has been legally authorised and distributed to the prospective investors, the Limited Partners (LPs). The GP can delegate the responsibilities such as day to day management or accounting to professional firms but the overall responsibility and accountability is with the GP. In the normal course of business GP delegates, the day to day management of the Fund to a fund manager who sub delegate’s components like accounting, cash management, investor services and financial reporting to specialise firm which assist the fund manager to focus their time on investment strategies and business expansion. Let us look into the world of Private Equity:
Types of Private Equity
As the interest in the Private Equity developed and the traditional hedge funds lost a bit of their charm, there have been many new structures and strategies build by the investment managers that gave versatility to the Private Equity world. There are various private equity funds that operate across the world; following are some of the types that have gained popularity in last decade or so:
• Venture Capital
Invest in start-ups that have high growth potential and require smaller amount of investments.
• Buyout/Leveraged Buyout (LBO)
This type of private equity fund will buy an establish business and get full control over its operations. The Fund using investors money and debt to enhance the business and the Return on Investments (ROI). If successful at this stage the Fund moves to acquire companies.
• Fund of Funds
As the name suggest this type of private equity funds invests in other similar funds. It uses the investor money to invest fund that have well defined investment strategies that are managed by well-known investment managers. This can be costly for the investors as it forms another layer of fees and charges that are deducted by other funds.
• Distressed Funds
This is an opportunistic and high-risk type of fund that rather than investing in a start-up or an established business, it invests in struggling companies and uses the investor funds to boost its business or diversify it and gain significant profits. Most private equity funds will be invested into companies that are looking set for growth, but some investors may make special arrangements with a struggling company. By investing in a company in a worse-for-wear position, not only can the investor buy in cheaply; in fact, if they succeed in boosting the profits, their ROI could be significant.
• Growth Capital
The fund invests in established business with low risk of failure. There is already a stream of profits which will get some boost because of the cash injection.
• Real Estate
Real Estate has its own world of investments and involves using the capital from its LPs to invest in various real estate projects that includes properties and lands. It has its own strategies ranging from low to high risk.
• Mezzanine Financing
This type of fund uses both Debt and equity financing. The benefit of such strategy is that it allows capital injection without giving up equity ownership. On the flip side, interest rates are higher and terms can be disadvantageous than traditional debt financing.
Fees and Structure
For the day to day management and return on investments the GP charges management fees and carried interest from the LP. Management fees are calculated as a percentage of the committed capital and are typically charged on a quarterly basis. The can be instances where it is deferred for certain period. Carried interest is the percentage of profits that the GP is entitled to receive on top of management fees documented in the LPA. Carried interest is the profits taken by the GP against realized profits on sale of investments. Generally carried interest is 20% of the proceeds after the original capital plus a preferred return is given to the LP.
A lot of documentation is involved when setting up the Fund and over the course of its existence. Some of these are mentioned below:
• Offering Memorandum
This is a general disclosure document that includes terms and conditions for the investors, investment strategies and risks and details of people in charge of the day to day operations and their background. This is generally a marketing instrument use to get the prospective investors.
• Limited Partnership Agreement (LPA)
This is a very important document referred to not only by people signing in to become the LPs but also by the auditors, accounting firms, investors services team and others, to ensure they are doing their tasks in line with the requirements as prescribed in there. This document sets forth the rights and responsibility of the GP and LPs, allocations of profits, clawbacks and fees. It also clarifies any restrictions and details events when the fund can cease to exist. There can be amendments to the LPA depending on the circumstance and issuance of side letters.
• Subscription Agreement (LPA)
A subscription Agreement defines the terms and conditions to the LPs such as amount required to be committed, minimum threshold, closing conditions. It is normally accompanied with the memorandum.
One of the important aspects that the GP focuses on is the domicile of the fund. The consideration is based on tax laws and regulatory framework. In certain cases, the time to get the approval from the relevant authority can play an important role.
Private Equity Funds have their own complexities, few of them are discussed below:
• Waterfall Methodology
Waterfall calculation is the method of allocating the profits share to GP and LPs as per the agreed ratio in the LP. This calculation can be complicated and very challenging to automate due to the variables involved such as clawbacks, side letters and events that trigger certain clauses in the agreement.
Valuations of the investment in a private equity fund involve a lot of intricacies like projecting future cashflow or data analysis from different sources. This is specially challenging when it comes to the audit and getting the comfort over the valuation method. There is a lot of effort and back up completed by the investment managers in order to value the investment per the applicable accounting standards.
There are certain regulations that the Private Equity Funds must follow which depends on where the fund, its investors and the Investment Manager are domiciled. Some of them are highlighted below:
Employee Retirement Income Security Act (ERISA)
US GAAP for reporting
Investment Company Act
Investment Advisers Act
Securities Exchange Act
The Alternative Investment Fund Managers Directive (AIFMD)
The European Venture Capital Fund Regulation (EuVECA)
European Securities and Markets Authority (ESMA)
Directive/Capital Requirements Regulation (CRD/CRR) framework
IFRS or Local GAAP reporting
The Private Equity world is full of opportunity and growth, but it also has it won challenges to overcome. Where as the industry is still growing the regulation can become strict due because of Brexit or even Covid-19. What happens in future we will have to wait and see. I hope that the above overview of Private equity Fund and its complexities are helpful in gaining some basic understanding of how what are these structures and their nature.
Mr. Ali Boricha, Author has over 18 years of experience in Financial Reporting, Internal controls over reporting and Accounting with Global Organizations. Qualified in 2003 and he pursed some additional qualifications as gained more knowledge of different working environments and cultures. Most of my experience relates to Financial Services especially Private Equity, Real Estate, Hedge Funds and Mutual Funds but I have exposure to non-financial services client as well. He is based in Ireland with Multidimensional organisation world-wide.
Disclaimer: The content of this article is for information only and is not offered as an advice. Readers are encouraged to consult a suitably qualified professional adviser to obtain advice tailored to their specific requirement.