What is Private Equity and How Does it Work?

New to private equity? Our private market strategists answer the most frequently asked questions from our clients about this dynamic alternative asset class.

What is private equity?

Private equity is an alternative asset class where companies can raise funds outside of the public markets. It includes different fund strategies, the most fundamental being private equity (PE) and venture capital (VC) funds.

What’s the difference between private equity and venture capital?

PE funds buy mature companies, often in traditional industries, and look to make them more profitable by improving their management, business strategy and operations. An advantage of investing in established companies is that they come with a lower risk of failure, compared with young companies, or startups.

PE funds usually buy a majority stake in a private company, but they can also purchase public companies and take them private. These initial investments occur either through a management buyout, involving the purchase of equity, or a leveraged buyout (LBO). 

VC funds will primarily invest in startups they think have significant growth possibilities. They are very often in industries benefiting from secular thematic investing trends, like artificial intelligence, cybersecurity, healthcare technology, software, and biotechnology.

VC funds can offer investors a much higher potential return on their money than more traditional investments, but they also come with higher risk, given the early growth stage of the companies. Even so, investors in venture capital have the kind of wealth where they can have most of their money in lower-risk traditional investments, while devoting a small percentage of their portfolios to higher-risk venture capital.

How do private equity and venture capital funds work?

A PE or VC fund is run by a team of professionals hired by a general partner, who could be a person or a legal entity. A general partner manages the fund and chooses the investments. A general partner is also responsible for raising capital commitments from outside investors, called limited partners.

Limited partners are typically institutions like pension funds, university endowments, foundations, and insurance companies, but can also be high-net-worth individuals.

When a fund raises money, limited partners agree to specific investment terms presented in a limited partnership agreement. They need to make a specific minimum “capital commitment” to enter a fund.

Limited partners don’t influence a fund’s investment decisions, and they won’t know the total size of the fund when they each make their capital commitments. But their risk is limited to their own investment in a fund. The general partner is responsible for any debt or obligations the fund owes.

General partners typically exit each portfolio company within a set period, based on the partnership terms. But that timeframe can be affected by negative market conditions, such as periods when various exit options (such as Initial Public Offerings) aren’t attractive.

What is the difference between “capital committed” and “capital called”?

"Capital committed" is the total amount of capital commitments made by limited partners into a fund. It’s also called the fund size. The capital you commit to a fund will typically sit in a liquid account, like a money market fund or escrow account, until the general partner finds a new investment and makes a “capital call” to limited partners to pay for it.

A capital call is for a percentage of the capital each limited partner has committed. Capital calls happen at different times during the investing period, which is typically the first three to five years of a fund’s life. Capital calls don’t happen at a set time, and can differ in size, based on a general partner’s needs. They also cover the fund’s operational and management costs.

How can you invest in private equity?

There are several ways to invest in private equity. You can invest directly into underlying companies in the same way PE and VC firms do. You can also invest in a single PE or VC fund. However, both options carry high levels of risk and may require large allocations if you want to attain an appropriate amount of diversification in your private equity portfolio.

Another way for individuals to get exposure to private equity is by investing in a “fund of funds” which invests in a range of different PE or VC funds. The advantage is that it offers an investor instant diversification of underlying fund manager performance, strategies, geographies, and vintage years.

These multi-manager funds are also run by professional managers at firms like BNY Mellon Wealth Management, who bring the necessary expertise and industry relationships needed to access highly sought-after PE and VC fund managers. Having access to the best PE and VC funds is critical for success. Research suggests that top-ranked funds have outperformed bottom ranked funds by an average internal rate of return (IRR) of 25% for the last 20 years.1

What is the lockup period for private equity?

PE or VC firms typically have a 10-year term plus a year or two of extension to allow general partners time to spot attractive investments, grow those businesses, and time exits with favorable market conditions. That said, the average time before limited partners get their invested capital back is typically closer to seven or eight years, because the portfolio companies will be sold at various points of a fund’s life.

When will I get my initial investment back?

Most private equity funds begin returning capital to investors after about three or four years.

What is the minimum investment level?

The capital commitment a limited partner needs to make will depend on the fund, but often the minimum investment will be around $250,000 for individuals in the case of a feeder fund or fund of funds vehicle, and a few million dollars for institutions that want to invest directly with a fund manager. 

What do we do with capital waiting to be deployed?

If you have just started investing in private equity, you may want to consider allocating capital to a private equity secondaries fund, in addition to a typical PE investing vehicle like a PE or VC fund of funds. Secondaries provide exposure to more mature companies which are closer to being realized. This will help you ramp up exposure as well as get earlier distributions. You should recognize, however, that secondaries often generate much lower multiples, given the faster velocity of capital.

Can I withdraw my investment at any time?

Private equity funds typically impose limitations on an investor’s ability to withdraw their investment. When you invest in private equity strategies, you will be expected to wait the requisite time before getting a return on your investment. PE and VC funds are illiquid, because of the long-term investment horizon and nature of the underlying companies.

Why would I get distributions and still have capital that has been committed but not called?

Distributions occur when underlying fund investments are harvested (sold) and paid out to the limited partners. There will likely be instances when early investments are harvested before all the committed capital has been called.

What are the fees and how are they paid?

There are two main fees:

1. The Management fee. This is an annual management fee that is charged to the limited partners to pay for the expenses of managing the operations of a fund and is paid from money received from capital calls.

2. The Performance fee (also known as carried interest or carry). This is the payment made to the general partner for generating a positive return. This can be calculated in many ways, but the most common is a percentage of investment profits, often both realized and unrealized.

What is a preferred return?

The preferred return (or hurdle rate) is the minimum annual return that the limited partners must receive before the general partner can receive any performance fee.

How do you measure performance?

There are several ways to measure private equity performance. The most popular metrics include Internal Rate of Return, Multiple (X), Total Value to Paid-In Capital (TVPI), Distributions to Paid-In Capital (DPI), and Remaining Value to Paid-In Capital (RVPI).

What is Net IRR?

The net Internal Rate of Return (IRR) is a financial metric that’s used to measure an investment's quality or yield, by providing its expected rate of return. It is defined as the rate at which the net present value of the negative cash flows equals the net present value of the positive cash flows.

Why doesn’t the value of my investment get updated regularly?

Given the greater number of inputs used to value private assets versus public assets, as well as procedural hurdles, which often include annual audits and third-party valuations, the process of striking a net asset value is conducted on a quarterly basis and typically takes several weeks. This means that new data regarding a company’s performance is not reflected in actual valuations until statements are released, typically 45-to-60 days after quarter-end.

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    Source: Cambridge Associates, Preqin and Morningstar. Asset class returns over 20-year period ending 12/31/2021. For illustrative purposes only. Past performance is no guarantee of future results. No investment strategy or risk management technique can guarantee returns in any market environment. This material is not intended to constitute legal, tax investment or financial advice.

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