An introduction to private equity funds

By Jim Cole, Investing Across Borders

for ScudderWeisel.com

Federal Express, Henry Ford’s assembly lines, Minute Maid’s invention of orange juice concentrate, the Safeway supermarket chain -- they all grew with the help of private equity investments (from early-stage to, in Safeway’s case, leveraged buyout funding).

In each case investors saw value in the business or the business concept and risked their own money to finance growth -- and reaped solid, long-term profits on their investments.

Private equity -- generally, long-term, illiquid investments in companies whose shares are not publicly traded -- has been around for more than 50 years. The term encompasses leveraged buyouts (LBOs), mezzanine debt and distressed debt, but it is most commonly associated with venture capital – investments in risky startups. Because of their risks and long-term nature, these types of investments have traditionally been the land of large institutional investors, such as pension funds, and the ultra-wealthy -- players with the $1 million to $5 million minimum investment that had generally been required.

Institutional investors use private equity investments and other alternative investments, such as hedge funds and real estate, to try to increase long-term returns on their portfolios and to reduce risk by diversifying their portfolios beyond publicly traded securities.

Recently, barriers to entry for individual investors have been lowered, making private-equity investing accessible to qualified high-net worth individuals.

How to invest in private equity

Private equity is used to describe any investment in a private company. There are a number of ways investors can participate in the potential growth of private companies. They include:

When someone puts money into a private-equity fund what happens? The money goes into a pool along with money from other investors in the fund. Funds are typically of a specific size and when the fund is fully raised, it is closed to new investors. The money is not necessarily invested immediately. Instead, when enough money is in the fund and an attractive investment has been identified, the fund manager will draw from the pool and put the money to work in a private company.

Private equity fund managers and venture capitalists conduct extensive research into a company and its management team before making an investment. A venture capitalist’s success in picking a company that will be a super-star two to five or more years out hinges on this process, known as due diligence, and on the ability to peg how a company fits into broader business and economic trends.

Once money goes into a private-equity fund, it is there to stay for a long time (though some funds provide windows for limited withdrawals). Fund managers put the money to use in private companies, who, in turn, spend the money to build their businesses. That doesn’t leave much opportunity for investors to withdraw their money from funds, which typically have a lifespan of around 10 years.

A unique aspect of private equity is that fund managers routinely invest in their fund alongside outside investors. This aligns the fund manager’s interests with those of the investors. Investors pay the fund manager an annual management fee of a few percentage points of assets raised, but the fund manager is really working for an incentive fee, typically 20 percent of investment profits. Though that fee seems high, it is the incentive that motivates the manager to try to pick the winners in which the fund will invest.

Exit Strategies

If the private company is successful, its business grows and increases in value. If the company is not successful (and this is the big risk in private equity) its value declines and it may fold or be sold off in bits and pieces to salvage some value for investors. The fund reaps the benefits of its successful investments only when an event, known as a liquidity event, occurs. These events include:

When these events occur, the proceeds go to the fund in the form of cash or shares. Based on the terms of the fund prospectus or limited partnership agreement, those proceeds can be reinvested in the fund, which can hold them or invest in other private companies. Or the proceeds can be distributed to the investors in the fund.

Private equity, hedged portfolios and growth capital

Some of America's largest institutional investors seek to capitalize on the strong performance potential of these alternative investment opportunities and the diversification characteristics they add to their portfolios.

For additional information on private equity investment opportunities, please consult a registered investment professional.