The investors in private equity are essentially large international institutions. Most of the funds raised come from public or private pension funds, fund-of-funds, life insurance companies, foundations and endowments or banks. A new trend is that smaller investors and individuals can invest in private equity funds by way of listed vehicles or funds.
Other than seeking higher returns investors also invest in private equity in order to achieve portfolio diversification and to spread their risk. Even if private equity is cyclical the correlation to public markets is limited.
Private equity companies
In the early days private equity companies were often owned by different banks but today the majority of all private equity activity is undertaken by independent private equity firms owned by their management and leading professionals. These executives are expected to commit their own capital to the funds, investing in parallel with their investors, typically with between 1 and 3 percent of the total capital committed. This is a requirement from fund investors who thereby secure that their interests are aligned with the manager of the fund, the so called General Partner.
The funds have no permanent capital and instead investors commit to contributing capital up to a predetermined level as drawn by the investment manager to make investments into various portfolio companies and to cover the costs of the fund.
For larger international funds the most common structure is the English Limited Partnership, a structure well known to international investors since it has been in place since the industry emerged. This structure avoids double taxation of investors with different domiciles. Investors pay tax when the fund’s investments are divested in the same way as if they had owned the underlying companies directly. The investors enter into an agreement with the manager of the fund, the so called General Partner, concerning the management of the fund’s activity. The General Partner then selects and enters into agreements with an advisor, the so called Investment Advisor, who assist in the search for and analysis of various investment and exit opportunities. The investment or exit decisions are taken by the board of the General Partner.
A private equity fund as described above has normally no idle cash which has to be managed but only holdings in various portfolio companies. It is common that the fund’s ownership in the portfolio company is organised through a holding company. This structure does not affect the taxation of the underlying portfolio company’s revenues, its cost structure or regular taxation. The portfolio company pays the usual taxes in the countries where it has operations and where it is domiciled.
A fund is typically invested over a three to six year period. When the fund exits a portfolio company the proceeds are normally immediately returned to the investors, which means that every fund has a limited life span, typically between eight and 13 years. A new fund is therefore usually raised when the previous is fully invested, typically after three to five years. At every such fund-raising an extensive evaluation and due diligence is made of the private equity firm, its operations and track record. If investors are not satisfied with the result of such an evaluation they will not invest in the fund.
The private equity firms report back to their investors on a regular basis, usually quarterly, in accordance with established industry guidelines for reporting and valuation of portfolio companies. Regular communication in connection with new investments and/or divestments is also common as is an annual investor meeting.
A private equity investment in a company involves a transformational, value-added, active management strategy.
The private equity fund is seeking a high-quality management team and a strategic plan to grow and improve the business. Private equity investors usually own the business for a number of years and work with the company's management to develop and improve performance, operations and strategic direction.
Over the past few decades, private equity has grown to represent a strong force in the economies of Western Europe and North America and today exerts substantial influence on the developed economies and many long-term portfolios held by institutional investors.
In general private equity works with three steps; the transaction or investment, the development of the portfolio company and then an exit, i.e. the sale of the company to a new owner.
A crucial part of the operations of a private equity fund is to secure a good supply of promising investment opportunities or companies with development potential - a deal flow.
The investment opportunities typically arise from family businesses seeking new owners, spin-outs from larger corporations or from private equity funds that operate at an earlier stage in the value chain and have developed and financed the company as far as they can. Privatisations and public to private transactions of listed companies are other sources.