Private equity is money that is invested by individuals and funds that are used to make an investment in a private company or to take a publicly traded company private. The funds in use by private equity may be raised by using institutional and retail investors. Capital from private equity is used to make an acquisition or to provide funding for new technologies. A private equity firm will try to improve financial results of an acquisition to sell at a later time or take it public. Familiarity with terms used with private equity is a benefit when discussing investments.
These are institutional investors or investors with high net worth that will receive capital gains and any income when making an investment in a private equity fund. A limited partner is not involved with any aspect of the management of a fund. Investors are protected from litigation taken against the fund or from losses that exceed their original investment.
These are people that are actively managing capital that has been invested in a private equity fund. The general partners receive a percentage of the profits made by the fund known as carried interest and will earn management fees. A general partner is also legally liable for any actions taken by the fund.
Compensation for general partners will come from any management fees or carried interest. The share of profits of an investment in a private equity fund is carried interest. The amount of carried interest on a fund is often between 5 and 30 percent of the total profit. Management fees are about 2 percent on all investments made each year.
Two clauses are typically found in the compensation agreements for private equity funds. There will be a return provision and a clawback provision. The return provision is a minimum annual return a limited partner is entitled before any general partners receive any carried interest. The preferred return is called the hurdle rate and is typically about 8 percent. The clawback provision for a private equity fund allows a limited partner to get back some of the carried interest from a general partner. This occurs when a general partner has withheld a higher percentage of carried interest from future investments.
Residual Value and Cumulative Distribution
The residual value for a private equity fund is defined as the market value of the equity that remains for all limited partners in a fund. The cumulative distribution is the amount of stock or cash that is paid out to a limited partner. There are important factors for the track record of a fund.
Investors that are interested in private equity need to have an understanding of basic terms that are used to make smart investment decisions.
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