Unlocking the Mysteries of Private Equity: A Guide to How it Works

It typically involves identifying the key challenges and opportunities facing the operation of the fund and developing a roadmap for achieving long-term success. The management of the fund should be done in accordance with the strategy with the adjustments implemented as a reaction to a changing market. 

The General Partner is responsible for producing all necessary offering materials before launching a fund, including documents aimed at attracting prospective Limited Partners. These materials typically include three main documents, a Private Placement Memorandum, a Due Diligence Questionnaire, and a Marketing Presentation, which vary in level of detail.

It’s a legal document that is used to disclose information to potential investors in a private placement offering, such as a private equity fund or a startup seeking to raise capital. The purpose of the PPM is to provide potential investors with all the necessary information they need to make an informed investment decision. Standard sections of PPM are the following:
1. Executive summary
2. Investment performance
3. Summary of Key Fund Terms
4. General Partner Overview
5. Investment Team
6. Investment Strategy
7. Industry Opportunity
8. Key Fund Terms
9. Appendices

A due diligence questionnaire is a comprehensive set of questions that is used to gather information about a company or business in the context of a potential investment or acquisition. The purpose of the questionnaire is to help the investor or acquirer gain a thorough understanding of the target company’s operations, financial performance, legal and regulatory compliance, and other relevant factors.

It’s a shortened version of PPM that highlights arguments for Limited Partners to commit capital. It’s typically 30-50 slides long.

At this stage, the General Partner announces the launch of the fund and invites prospective Limited Partners to commit capital. As there are multiple Limited Partners involved in the fund, this stage involves a continuous exchange of information between the General Partner and prospective Limited Partners. This may involve answering questions and negotiating fund documents in order to reach an agreement that satisfies both parties.

The development of a deal pipeline refers to the process of identifying and sourcing potential investment opportunities for a private equity fund. This involves establishing relationships with intermediaries, such as investment banks and brokers, as well as conducting research to identify attractive investment prospects. In case deals have been secured before the fund completes its capital-raising process, the investments are put in a holding state, commonly known as “warehousing,” and are frequently utilized to promote the fund to potential investors.

The initial closing is the first round of capital-raising for a private equity fund. It occurs when the fund reaches its minimum target size and begins to deploy capital towards investment opportunities. At the initial closing, the general partner of the fund will start drawing down commitments from the limited partners who have committed capital to the fund. The initial closing is typically followed by subsequent closings, during which additional limited partners can commit capital to the fund. This allows the fund to raise additional capital and increase its size beyond the initial target. The initial closing is an important milestone for the private equity fund.

Management fees in private equity refer to the regular charges paid by limited partners to the general partner for managing the private equity fund. These fees are typically calculated as a percentage of the total committed capital and are paid annually throughout the life of the fund. 

The management fees are intended to cover the general partner’s expenses, such as salaries, office rent, and other operational costs associated with managing the fund. It is common for management fees to decline over time as the fund approaches the end of its investment period.

In private equity, deal sourcing typically involves leveraging personal networks, industry relationships, and market research to identify potential investment opportunities. Private equity firms may also work with investment bankers, brokers, and other intermediaries to source deals.

Once potential investments are identified, private equity firms conduct due diligence to evaluate the investment opportunity’s financial performance, market positioning, and growth potential. This process involves analyzing the company’s financial statements, interviewing management, conducting market research, and reviewing legal and regulatory documents.

Capital calls in private equity refer to the process by which the general partner of a private equity fund requests additional capital from its limited partners. Private equity funds are typically structured as limited partnerships, with the general partner acting as the investment manager of the fund and the limited partners providing the capital.

When the general partner identifies a new investment opportunity or requires additional funds to manage existing investments, it may issue a capital call to the limited partners. The limited partners are then required to contribute the specified amount of capital within a designated timeframe.

The primary objective of a private equity firm is to achieve the highest possible value upon exit of an investment. Throughout the holding period, which is the duration between making the investment and liquidating it, the General Partner takes an active role in adding value to the portfolio company. The specific value creation initiatives undertaken by the General Partner may vary depending on the fund’s strategy, with different levels of involvement. 

Operational transformation has become increasingly important in modern private equity as firms seek to maximize value creation in their portfolio companies. Rather than relying solely on financial engineering and cost-cutting measures, private equity firms are now taking a more proactive approach to driving operational improvement.

This approach involves identifying and implementing operational improvements across all areas of the business, including supply chain management, sales and marketing, and technology infrastructure.

The buy-and-build strategy is a popular approach used by private equity firms to create value in their portfolio companies. This strategy involves acquiring a platform company and then using it as a foundation to acquire other complementary businesses in the same or related industries. The goal of the buy-and-build strategy is to create a larger, more diversified business with improved operational efficiencies and a stronger competitive position in the market.

Deleveraging is a common strategy used by private equity firms to reduce the debt levels of their portfolio companies. When a private equity firm acquires a company, it typically uses a significant amount of debt to finance the purchase. This debt is commonly known as leverage.

Once the portfolio company has been acquired, the private equity firm may implement a deleveraging strategy to reduce the company’s debt levels. This may involve selling non-core assets, improving operational efficiencies to increase cash flow, and using the proceeds to pay down debt.

Follow-on investments are additional investments made by private equity firms into portfolio companies in which they have already invested. These investments are typically made to provide additional growth capital or to support the company’s expansion plans.

Private equity firms may make follow-on investments for a variety of reasons, including to take advantage of attractive growth opportunities or to support the company during challenging economic conditions. Follow-on investments can also be used to fund acquisitions, debt repayments, or capital expenditures.

Dividend recapitalizations, commonly known as dividend recaps, are a type of financial transaction used by private equity firms to generate cash returns from their portfolio companies. In a dividend recap, the private equity firm takes on additional debt to pay a large dividend to itself or its investors, typically funded by the portfolio company’s existing cash reserves or a new debt facility.

Dividend recaps can be an attractive option for private equity firms looking to generate liquidity from their portfolio companies without selling them outright. This strategy allows the firm to monetize a portion of its investment while retaining ownership of the company and the potential for future value creation.

An Initial Public Offering (IPO) is a process through which a private company goes public by offering its shares for sale on a public stock exchange. For private equity firms, an IPO represents a potential exit strategy from a portfolio company, allowing them to realize their investment in the form of public stock.

Before the IPO process can begin, the private equity firm must prepare the portfolio company for public ownership by conducting an initial public offering readiness assessment, which includes reviewing the company’s financial and accounting records, corporate governance practices, and internal controls.

A strategic sale is a common exit strategy used by private equity firms to realize their investment in a portfolio company. In a strategic sale, the private equity firm sells the company to a strategic buyer, typically a competitor or another company in the same industry, in order to maximize the value of the investment.

The private equity firm may initiate a strategic sale process by hiring an investment bank to conduct a thorough analysis of the portfolio company’s financial performance, market position, and strategic fit with potential buyers. This analysis may also include a review of the company’s management team, operations, and customer relationships.

In private equity, cash flows are distributed to investors in a “waterfall” structure, which consists of four tiers that are typically customized to the fund’s specific terms. Once the General Partner begins to exit investments or conduct dividend recapitalizations, cash will enter the fund and be distributed to investors in each tier before moving to the next.

The first tier involves returning the capital to Limited Partners until they have received the full amount they initially contributed to the fund. The next tier involves distributing a “preferred return” to Limited Partners, typically set at 8% but may vary depending on the offering materials.

The third tier involves a “catch-up” provision where the General Partner receives distributions until they have reached their predetermined percentage of carried interest, which is often set at the industry standard of 20%. At this point, profits are split with the General Partner receiving 20% and the Limited Partners receiving 80%. All future distributions follow this 20/80 split.

Fund close in private equity refers to the process by which a private equity fund reaches its fundraising target and stops accepting new capital commitments from investors. It may take somewhere from several months to several years.