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Accredited Investor Installment 10: Private Equity, aka PE Investments

[Editor’s Note:  Focusing on PE investments, this is the tenth installment in a series of articles dedicated to the 95% of people in the U.S. who have never invested in a startup, a venture capital fund, a private equity fund, or a hedge fund even though they are permitted to do so and even though doing so may make sense to achieve property diversification. Read Installments #1, #2 , #3, #4, #5, #6, #7, #8 & #9.]

What is Private Equity (aka PE Investments)?

In the traditional fund model (the “committed” or “blind pool” model) a management team or “sponsor” will organize a fund and serve as its general partner. The sponsor will then raise binding capital commitments from a group of passive investors (who will make up the fund’s limited partners) in a private placement of the fund’s ownership interests.

Typical fund investors include public and private employee benefit plans, university endowments, insurance companies, banks, sovereign wealth funds, family offices and individual accredited investors.

Taking a step back, a private equity fund is like a mutual fund except that (a) instead of accepting investment funds from just about anyone, PE funds only accept investment funds from accredited investors; and (b) instead of pooling the money from their investors to buy large stakes of publicly traded companies, PE funds invest in (or buy outright) privately held companies.

The Similarities of PE Investments and VC

We explained earlier how PE investment and VC differ. However, there are also quite a number of similarities. In fact, everything you read above applies equally to VC funds.

In addition, an investor’s relationship with a fund (be it a VC or PE investment fund) is, as you will read below, quite similar.

PE and VC funds also share quite similar life cycles, generally consisting of four basic periods: (a) the capital raise, (b) the investment period, (c) the holding period, and (d) the harvesting period.

The Capital Raise

As mentioned above, the traditional fund model seeks commitments from potential investors, to invest in a fund. Once committed, the investors are “limited partners” of the fund.

By example, you might agree to invest $50,000. You do not write a $50,000 check the day you commit. Rather, you commit to write checks, up to a total of $50,000, when instructed.  Thus, you make a “binding capital commitment.”

Later, when you receive such an instruction, it is called a “capital call.” Once a fund has secured a sufficient level of binding capital commitments, it moves from the capital raise period to the investment period.

Investment Period

During the investment period, with the assistance of an investment management firm or investment advisor (who typically is an affiliate of the fund’s sponsor), the fund seeks out companies to invest in (in the case of a VC fund) or companies to purchase (in the case of a PE fund). As the fund executes investments, the sponsor makes capital calls on its investors.  The investment period typically spans the first three to five years of a fund’s life.

Holding Period

Following the investment period, and during the holding period, a fund will maintain the investments in its portfolio for a period of five to seven years while they develop and appreciate in value. While both VC and PE funds actively help their portfolio companies, PE funds tend to be more hands on. It is also common for funds to support their portfolio companies in making “follow-on” investments during the holding period or in making them themselves.

By example, if PE firm X buys an eyeglass frame manufacturer during the investment period, it may end up buying a second eyeglass frame manufacturer or, perhaps, a contact lens manufacturer, or a chain of optometry shops later, even if it’s during the holding period. Or it may help its original portfolio company to buy it by providing the funds to do so.

Harvesting

Lastly, during the harvesting period, a fund will liquidate its portfolio of investments and distribute proceeds to its investors. To be clear, these four periods do not have rigid lines and, in fact, overlap a great deal.

Historical Overview

The private equity firm of today, it is generally agreed, traces its origin back to American Research and Development Corporation, founded in 1946. As explained in the book Private Equity, History, Governance, and Operations (Wiley Finance, 2008), however, the industry had forerunners in the form of U.S. governmental institutions that were created to address needs brought on by the two world wars and the intervening Great Depression.

The golden age of the leveraged buyout (LBO) came in the late 1980s when players like KKR and Michael Milken engineered large leveraged buyouts. Since then, as superior returns encouraged more investment in the asset class and as the number of funds proliferated as a natural consequence of fund managers leaving one firm to found a new one, the industry continued to grow into what it is today. A good example of this can be seen by looking at the legendary PE firm, Golder Thoma & Co.

Established in 1980 by Stanley Golder and Carl Thoma, Golder Thoma & Co. originated the “consolidation” or “buy and build” investment strategy, which sought to combine the best of venture investing with the best of leveraged buyouts. This was done by investing in a “platform” business (an acquisition in a new area of business intended to be a ‘platform’ onto which to add other businesses, in order to build something new) in a fragmented industry and then working with management to transform it into a larger and more profitable business through internal growth and a series of strategic, industry consolidating acquisitions.

Golder and Thoma worked together at First Chicago Corp. before founding Golder Thoma & Co. Looking at one branch of the genealogy, Golder Thoma & Co. eventually split into Thoma Bravo and GTCR. Looking at a different branch, John Canning took Stanley Golder’s place at First Chicago Corp. and Canning ultimately left to form Madison Dearborn. These three firms are now among the largest and most prominent PE firms.

Basic choices for PE investments

The fund type described above is the traditional model. There are other models that you should be aware of.

Fundless Sponsors (aka Pledge Funds)

In the world of middle-market buyouts, non-traditional funds (or fund-like groups) are playing an increasingly active role in the private equity domain. They include family offices, accredited investors making direct investments in businesses, and pledge funds.

Private equity groups identify, source, and execute deals using capital committed by their investors. By contrast, fundless sponsors (also sometimes called “pledge funds,” though we think that term is misleading) do not raise a committed fund, and thus do not charge up-front management fees. They may charge a fee to their portfolio companies, but only after an investment is in place.

Fundless sponsors build a network of investors and present opportunities to them on a deal-by-deal basis, to gain capital commitments to specific deals, rather than through an aggregate pool of money.  Fundless sponsors operate like private equity groups in most other ways with respect to trying to create value for their portfolio companies through operational and strategic guidance.

In recent years, there has been a trend among limited partners to push back on large up-front fees. As a consequence, there are far more fundless sponsors today than there used to be. The difference between having a committed fund and operating as a fundless sponsor has a number of implications for both the investing process and investors.

Funds of Funds

A private equity fund of funds does not invest into companies directly. Instead the fund of funds takes the assets of its participants and invests them into portfolios of other private equity funds. These private equity funds are often boutique and top-tier funds, investing in diverse privately held companies.

An advantage of investing in a PE fund of funds is that doing so can provide you with managers of underlying private equity funds who are otherwise not accessible to individuals or even to family offices and small institutional investors. A fund of funds also offers reduced administrative burdens for investors by providing consolidated reporting and capital calls.

Strategies for Structuring PE investments

Private equity funds employ varied investment strategies for choosing a company to invest in (to be clear, PE funds usually buy an entire company or at least a controlling interest in a company). And, once a PE fund decides to buy a company, the way it structures its purchase will vary based on a variety of factors.

A PE firm’s investment strategy starts with its investment “mandate.” That is, a specific set of investment strategies and diversification policies. These can usually be found on a PE firm’s website.  A PE fund’s LPA (limited partnership agreement) will usually contain more detailed information in this regard, commonly in a section titled, “Investment policy guidelines.”

How, when, and in what fashion a PE firm chooses its portfolio companies can be categorized in several ways. For example:

  1. Lifecycle
    • Growth capital invests in slightly more mature companies that are growing and profitable; however, these companies have financial limitations. Such limitations inhibit further development and expansion. To generate capital, such companies sell equity but maintain majority ownership.
    • Leveraged buyouts (LBOs) concentrate on the acquisition of mature, stable companies. The transaction is financed by two sources: equity (selling the ownership of the company) and debt (borrowing money to use as leverage). A “management buyout,” is a type of LBO in which the main buyer is the current management team, supported by a PE firm. Perhaps the best known LBO was that of RJR Nabisco by KKR in 1988. Bryan Burrough and John Helyar wrote about this in Barbarians at the Gate: The Fall of RJR Nabisco (Harper and Row, 1989).
    • Distressed investments and special situations pertain to investments in equity or debt securities of companies that are experiencing financial distress.
  2. The size of the company
  3. Geography
  4. Industry
  5. Investment size

All these factors influence how a PE firm narrows the range of potential portfolio companies. Once the company has been selected, private equity firms begin negotiations and conduct due diligence. Finally, the PE firm decides whether or not to invest in a particular company.

Structuring the Deal

Steven M. Davidoff identified the four main kinds of private equity deal structures being used by PE funds in the wake of the 2008-09 financial crisis. Writing for the New York Times’ DealBook blog, Davidoff described these four structures:

  1. All-equity financing. The private equity firm provides full equity financing for the transaction, providing equity financing letters for the equity. The target has full recourse to the private equity fund to collect the equity financing under these letters, and can demand specific performance (i.e., demand that the fund complete the transaction).
  2. Debt and equity financing with specific performance. The PE firm provides equity financing but also obtains debt financing from a consortium of banks. If the bank financing debt is available and the conditions to completion in the acquisition agreement are otherwise satisfied, the target can sue to force the private equity firm to complete the transaction. This means that the target can sue to force the buyer to draw on the equity commitment letters and, in some variations, force the private equity buyers to sue the debt providers to provide debt financing. If the financing fails, then a reverse termination fee is paid in the amount of four to 10 percent of the transaction value.
  3. Debt and equity financing without specific performance. This is a “reverse termination fee model.” The target cannot force the buyer to complete or specifically perform the acquisition. Instead, the buyer can walk for any reason. However, if a buyer does choose to walk away from the transaction, it is required to pay a reverse termination fee. This termination fee is typically four to 10 percent of the deal value and is the exclusive remedy.
  4. Debt and equity financing with two-tiered reverse termination fee. The purpose of the dichotomy (two tiers) is to separate unintentional breaches from breaches where the buyer is at fault. The higher reverse termination fee is payable if the breach of the agreement by the buyer is willful.

Read the full article by Davidoff (a professor at the University of Connecticut School of Law), which provides actual examples of each structure.

Understanding Your PE Investments

As an investor in a PE fund you do not own companies that a PE fund invests in and you have no claim against them. Other similarities to a VC fund concern fees structure and a limited partnership agreement. The details are as follows:

Fees

The fees you will pay to a fund manager in the PE context work the same ashey do in the VC context. You will recall from our discussion in Section 6.6.1 that “2 and 20” is the basic rule. That is, that the general partner (“GP”) charges: (a) an annual fee equal to 2% of assets under management plus (b) 20% of the profits of the fund (that is, after the limited partners are paid back their initial investment plus, sometimes, a preferred return, or “hurdle”). The preferred return, when there is one, typically is in the 5-10% range.

Details vary from fund to fund, with more established and successful sponsors being able to dictate compensation terms that are more favorable to them. Likewise, newer sponsors will often offer better terms to their investors to attract them. For example, some sponsors set up funds that require the sponsor to pay back the 2% management fee before the sponsor can receive its carried interest.

  • Sponsors often will charge two types of fees in addition to the two outlined above: (a) management fees and (b) transaction fees.
  • Management fees kick in once the PE fund purchases a portfolio company. Once a PE fund owns a company, the sponsor typically will charge the portfolio company a yearly fee for the time and attention it spends on the portfolio company.
  • Transaction fees (sometimes called “deal fees”) are simply additional fees a sponsor may charge to a portfolio company in connection with certain transactions.

According to the Economist:

[Private equity transaction fees] went up by at least 25% on average for 2009-10 deals that were $500m or larger, compared with deals done between 2005 and 2008. Deals between $500m and $1 billion, for example, had an average transaction fee of 1.24% of the deal amount in 2009-10, compared with 0.99% in 2005-08. “Monitoring”fees, which portfolio companies pay their private-equity owners each year for advisory services, also went up.

Managers of funds of funds typically charge a one percent annual management fee and a performance fee of five percent.  This is in addition to management fees and performance fees of the underlying funds.

The Limited Partnership Agreement

PE funds, like VC funds, are commonly set up as limited partnerships in which the sponsor is the general partner and the investors are all limited partners. LP agreements in the PE context read much like their VC cousins. See Section 6.6.2.

Is PE for you?

Investing in PE is inherently less risky than investing in VC because PE investments, by definition, involve purchases of business of reasonably large in size that have real revenue whereas VC investments often involve minority investments in new businesses that have no revenue or a limited track record of revenue. Like VC, however PC is subject to limited government regulation and oversight as compared to, for example, an investment in a publicly traded stock.

Another key consideration before committing to an investment in a PE fund is your investment horizon. That is, how long are you prepared to let your invested money sit in a given investment? A PE fund typically requires its investors (that is, its limited partners) to agree to tie up their money for an average of 10 years.

Why is this? Well, first the typical holding period of a portfolio company (the total amount of time between the purchase and sale of a portfolio company) is three to five years. And, it can take several years for a PE fund to locate suitable companies to purchase, conduct due diligence, negotiate transactions, and complete the purchase. Then, when a PE fund decides to sell a portfolio company, it cannot do so in the blink of an eye.

[Editor’s Note: To learn more about this and related topics, you may wish to attend the following webinars: The JOBS Act — A Retrospective & A Look Ahead 2018, and Investing Basics 2018.]

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About Jonathan Friedland

Jonathan Friedland is an attorney and entrepreneur. He founded DailyDAC in 2010 and launched Financial Poise in 2013. For more information on his legal practice, click here.

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