Private Equity Fund (PEF): vs Hedge Funds

Why called Private Equity

• Private: mainly interested in acquiring private companies that have not been listed on a stock exchange.

• Equity: exclusively focused on equity investments.

PEF target specific companies?

Yes, based on the life cycle stage:

1. Young firms with high growth perspectives and a promising management team

2. Established companies with stable cash flows leverage buyout transactions

3. Distressed companies (this overlaps with hedge funds).

Investment horizon

1) Private Equity

1. Try to acquire the entirety of shares of the target

2. Delist it

3. Change management

4. Introduce measures oriented towards improving financial performance

5. Be patient for at least a couple of years before exiting the investment through a sale or a new listing

2) Hedge Fund

1. Buy the securities of distressed companies when they believe that there is a good chance of reselling

2. Sell these securities with a profit, in no longer than 2 to 3 months

PEF structure

A. Limited partnership (much more popular in the US)

1. General partners: involved with the management of the fund, target company's portfolio selection and post investment advisory.

2. Limited partners: provide investment capital.

2-20% Compensation structure

1. General partners:

• Pays 2% as a management fee, even if the fund isn't successful.

• 20% of all proceeds after break-even are received by general partners.

• In some cases, a hurdle rate is added to the partnership agreement: a certain minimum rate of return that needs to be achieved before accruing carried interest to general partners.

2. Limited partners:

• Receive all of the funds proceeds minus what has been paid to general partners.

B. Closed-end fund (prevalently used in Europe)

• Typically involves a newly created entity.

• Investors provide capital to that entity and the management firm signs a management contract with the entity.

• Similar compensation structure.

Life cycle of a PE fund

1. Formation: a period allowing for the collection of investments in the fund.

• A couple of months or as long as 2 or 3 years.

• Largely depends on the reputation of the management firm and the demand for their services within the investment community. Hence, established players in the industry have a significant edge (ex. The Carlyle Group, BainCapital Private Equity).

2. Investment period

• Typically lasts up to 5 years.

• General partners or management company (depending on the type of fund structure chosen) search for suitable target companies fitting the funds strategy.

• Once an investment has been made, it would be up to fund managers to decide which is the right way to approach the business and optimize its performance.

• Advice for management and even management substitutions are very frequent when a private equity takes control. Most PE firms are very hands-on throughout the entire lifecycle of the investment.

3. Divestiture

• Could last several years, in some cases even 5.

• Various factors determine when is the best moment to exit business (ex. general state of the economy, market volatility, *finding the right buyer who is also willing to pay the right price).