WHAT IS PRIVATE EQUITY?
Investing in Private Companies
Private equity strategies generally involve investing in companies that are not publicly traded on stock exchanges. Private equity fund managers (also known as general partners or GPs) often seek to generate returns by enhancing the performance of their portfolio companies over the course of their holding period. Some of the steps that private equity fund managers take to do so include:
1. Strengthening the management team
2. Acquiring new businesses to help improve operations and/or access new markets
3. Shaping business strategy to position the company for future growth
4. Developing and launching new products
5. Streamlining and improving operations
6. Optimizing capital structure (the amount of debt and equity a company has)
Common Private Equity Strategies
Below are three common private equity strategies, each with unique risk and return characteristics.
ATTRIBUTES OF PRIVATE EQUITY INVESTMENTS
Private Equity Investments Typically Seek to Deliver...
- Larger Investment Universe
- Total Return
- Outperformance in Volatile Markets
The shrinking number of public companies highlights the need to diversify beyond them. There is a wide and diverse pool of private market companies that can offer potential diversification benefits.
Public Company Universe Is Shrinking1
Public vs. Private Company Annual Revenues2
1 Source: U.S. Bureau of Labor Statistics, World Bank, KKR. As of October 28, 2022. Note: The number of private firms includes those firms with more than 50 employees. For more information, please see “Regime Change: The Role of Private Equity in the ‘Traditional’ Portfolio.”
2 Capital IQ, last 12 months as of February 2023.
Private equity has historically outperformed public markets across time horizons.
Long-Term Outperformance vs. the MSCI World Index
Private equity has historically experienced strong relative performance when public equities falter. The chart below illustrates that the worse public markets performed (represented by the S&P total return ranges shown in the y-axis), the greater private equity outperformed (represented by the excess return of private equity vs. the S&P 500 shown in the x-axis).
Avg. 3yr Annualized Excess Total Return of U.S. Private Equity Relative to S&P 500 in Various Public Market Return Regimes
CONSIDERATIONS FOR PRIVATE EQUITY INVESTING
Private Equity Funds: Exploring the Basics
Understanding Private Equity Fund Fees
A distribution waterfall lays down the rules and procedures for the distribution of profits in a private equity investment agreement. The goal is to protect the interests of the investors and incentivize the general partner to maximize the returns of the fund. It derives its name from the cascading nature of its constituent tiers: Return of Capital, Preferred Return, and Profit Sharing Region (consisting of Catch-up and Carried Interest).
Total Proceeds ($1.2 Million)
- Return of Invested Capital
- Preferred Return Region
- Profit Sharing Region
Return of Invested Capital
- As long as the fund has a return, limited partners get back a minimum of their invested capital.
- In this example, $1M return of capital is received.
Preferred Return Region
- Limited partners are entitled to the returns of the fund up to the preferred return (or minimum rate of return / hurdle rate; in this example = 8%).
- In this example, after receiving $1M return of capital, investors are entitled to $80K of the remaining $200K profit (8% of $1M); $120K of fund profit remains.
Profit Sharing Region
- Once the minimum rate of return, or hurdle rate is reached, a share of profits is paid to the fund’s general manager as incentive compensation. This is called carried interest.
- In this example, after limited partners receive their 8%, general partners “catch-up” and receive the next 2% of profits to maintain the typical 80/20 split.
- After the full catch-up is met, the remaining amount of profit is allocated between the limited and general partners (usually 80% for limited partners and 20% for general partners).
- In this example, the limited partner receives a total of $1,160,000 and the general partner receives $40,000.
Evaluating Private Equity Fund Performance
Throughout the life cycle of a private equity investment, there are a few ways that investors can evaluate the performance of their investment. Multiple on Invested Capital (MOIC) and Internal Rate of Return (IRR) are two common metrics used to measure the performance of private equity funds. Both are an estimate at any point before capital is returned to investors. These metrics should not be viewed in isolation and should both be evaluated within the context of the other (as well as fees and expenses).
- Multiple On Invested Capital
- Internal Rate of Return
Multiple on Invested Capital (MOIC) is a metric used to describe the value or performance of an investment relative to its initial cost.
- Total return on a fund as a multiple of all money invested
- Measures how much value a fund has created
- Does not account for the time value of money nor varying amounts of capital
Internal Rate of Return (IRR) represents the time value of money.
- Internal rate of return (IRR) is the annual growth rate of an investment accounting for cash flows over time
- It calculates the rate which makes the present value of future cash inflows equal to the initial cash outlay for the investment
Evergreen Private Equity Structures
In addition to traditional private equity funds described above, the market also consists of newer, continuously offered private equity vehicles. Although every structure* is different, some of the typical characteristics of evergreen private equity vehicles include:
- Potential to buy and sell more frequently (with restrictions)
- No capital calls
- Automatic reinvestment
- Lower minimum purchase investments
- No termination date
*For example, 40 Act registered funds, 40 Act-exempt vehicles, BDCs, etc.
Explore Other Private Market Asset Classes
Dig deeper into three other private market asset classes to learn what they are, why they matter, and how they may fit within existing portfolios.