What is a private equity fund and how does it work?

A private equity fund is an alternative investment class that is made up of capital that is not listed on any public exchange and used to be called leveraged buyout funds/firms (LBO). Private equity is a pool of money that invests directly in private companies or engages in buyouts of public companies for the purpose of delisting them and flipping them for a profit.

Both institutional and private investors will provide the capital for the private equity that is managed professionally by a general partner and a series of limited partners. The private equity management usually takes over the invested company and streamlines operations to cut debt, fund new technology, make acquisitions, solidify a balance sheet and increase profitability to make it more attractive to prospective buyers.

Usually the backers of private equity funds will have a longer timeline to turn a profit on their investment. The companies they invest in are often distressed and the longer timeline is required to help turn the company around so that it can be profitably sold or taken public.

Advantages:

1. Some companies take advantage of private equity financing so as to avoid high interest bank loan payments.
2. Or to avoid the regulations required by a public listing.
3. Some startups or early stage companies can access private equity when there would be no other sources of funding available.
4. Because of the longer timelines involved some companies can pursue an unorthodox growth strategy or test out an unproven technology without the pressure of making quarterly profit numbers.

How does Private Equity work?

Private equity funds are usually what is called closed. This means that unlike a hedge fund or mutual fund once the initial funding period has finished, they do not accept more investors. Those investors who have pooled their money do so knowing that their money is tied up and not accessible to them for a significant period of time – usually 3-7 years.

Leveraged Buyouts: With an LBO a private equity fund will use a combination of debt and equity to fund the purchase of an entire company. The debt portion can be very high, sometimes as much as 90%, and this debt will get transferred to the acquired company. They do this to take advantage of tax regulations around company debt. The equity fund will then either slash the workforce, replace the management team or sell off non-core assets of the company (or all of these strategies) to improve profitability. Once the company has made a successful turnaround it begins generating profits for the fund.

Distressed Funding: Sometimes called vulture funding – here the private equity firm purchases under-performing companies with the express intention of chopping them up and selling the parts for a profit. These parts can include real estate, plant and equipment, and even intellectual property such as patents. Target companies are often found by looking at Chapter 11 bankruptcy declarations.

Real Estate Private Equity: Here funds are typically used to purchase commercial real estate and REITs. Often requiring investors to contribute a higher minimum sum to get started compared to other funding categories. The period that your money is locked in and inaccessible is usually on the longer end of the time scale as well.

Fund of funds: These types of private equity focus on investing in mutual funds or hedge funds. Perfect for the investor that cannot afford the minimum funding requirements of these large mutual and hedge funds.

Venture Capital: Made famous by many technology firms in Silicon Valley, this type of funding is sought after by startups. VC firms provide capital to entrepreneurs in seed funding rounds to scale an idea into a product or service. VC companies also provide funding to get a company over the hump so that sales explode. This has been made popular on the ‘Shark Tank’ reality television series.

Conclusion: Private equity firms earn millions in management fees and this is their primary source of income – at least until they sell the newly acquired company. Fee structures vary but the most common is what is known as 2 & 20. This means they charge 2% of the assets under management per year and then they take 20% of the profits on the sale of the company. As you can imagine this can be quite lucrative for the private equity partners.