What are Private Equity Funds

1. So… what exactly is a private equity fund?

A Private Equity Fund is a non-tradable investment fund (its stocks are not traded on any stock exchange) legally incorporated as a limited partnership[1] and managed by the General Partner (“GP”), which can be an individual or a company[2]. The investors in the fund are the Limited Partners (“LP”).

2. Background

The PE industry began in the USA in the 1940s but received increased awareness mainly in the 1980s, by significant PE participants of that time, such as KKR and Michael Milken. They specialized in buying companies through leveraged buyout transactions (LBO). Since then, the PE industry spread to additional countries and currently thousands of funds manage investments to the tune of hundreds of billions of dollars.

To put things in perspective, according to Investopedia’s comparative data from March 2020, the three largest funds alone manage approximately USD 1.2 trillion (AUM). Local PE funds operate in Israel, such as Fimi Fund, Tene Fund, and more.

3. Why are investment funds necessary?

Like everything in life, it’s the same with investments: where there’s a demand, there’ll be supply.

Tailor-made investment

Investing in the “classic” capital market doesn’t always provide an adequate solution to investors’ needs. As a result, new investment instruments are created. An example is the provision of financing for real estate transactions, which is usually identified with the banking system: within the tradeable market, it is possible to invest in shares of the relevant banks and be indirectly exposed to this area while also being exposed to other areas of the bank’s activities. By contrast, private equity funds can offer direct dedicated investment in this area through specialized funds.

Business expertise and capabilities

Unlike hedge funds or mutual funds, which usually invest in tradeable securities where the price is determined by market supply and demand, PE funds invest in non-tradeable securities where the price is determined in preliminary negotiations. As a result, PE funds have an actual impact on the business as well as additional strengths:

Usually, a relatively attractive purchase price at the time of the transaction

Active representation on the boards of directors of portfolio companies

Managerial added value which is likely to improve the position of the portfolio companies

Investment portfolio diversification

The investor return in a PE fund is based on real economic/business events, such as dividend distributions and/or the sale of portfolio companies, compared to the return in the tradeable capital market where exogenous events can affect the investor return without any real economic basis. The non-tradeable nature of PE funds can, therefore, help decrease the overall risk in the investment portfolio by reducing the correlation with capital market events.

4. How does the fund raise money?

The capital-raising process is usually conducted by the fund manager and/or through financial marketers, who present the fund to potential investors. These may include provident and pension funds, insurance companies, banks, and high-net-worth individual investors (HNWI). This “exclusive” investment fund club is not for everyone: deep pockets are needed, as well as the ability to thoroughly review the proposed investment, speed of response, and decision-making according to investment schedule. Taken together, these pose significant barriers to entry.

After making an investment decision, investors sign investment documents (LPA[3]) and must transfer the amount of their Capital commitment according to the Capital call dates during a pre-defined period called the “investment period.” In this time frame, the fund locates and acquires the investment assets according to the investment policy.

5. Is the fund term limited to a certain period?

Yes, the fund term is limited (in accordance with the investment documents) and usually ranges from 6-10 years with an option to extend (usually for an additional 1-2 years).

6. What are the existing types of funds and investment strategies?

Leveraged/Buyout Funds. The investment strategy is based on the acquisition of control of the companies while using a limited amount of the fund’s equity, and is based mainly on debt characterized by high levels of leverage. This strategy is based on an optimal Debt-to-Equity ratio to maximize the return on capital.

An investment strategy that includes buying existing investor (LP) positions in PE funds which are not open to new investments (the funds’ participation units will in most cases be acquired at a discount). The option to trade in secondaries provides some liquidity in a non-liquid area.

Fund of Funds. The fund invests in other PE funds rather than in companies themselves. This provides investment diversification to investors but doubles the management fees. This limitation can be bridged by providing incentives to investors, such as a relatively high Hurdle Rate, i.e. a higher expected return to investors.

Real Estate Funds. Funds that specialize in real estate investments. A wide variety of funds operate in a number of investment channels: yielding real estate, real estate development, bridge loans for real estate, and more.

Other funds (local and/or foreign) can be used to provide non-bank credit for first-tier and “mezzanine” (second-tier) loans, infrastructure funds, funds that specialize in energy, hedge funds (usually investing in tradeable securities, but the fund itself is not-tradeable ), and even financing for litigation purposes.

7. These basic investment fund terms are worth understanding:

(Internal Rate of Return). The fund’s internal rate of return is the annual rate of growth, the fund is expected to generate, which takes into account cash flow timing and size.

Multiple. Various multipliers are used to measure PE fund performance. Of particular note is the investment multiplier: that is, the total income received divided by the investment amount (equity investment). The rationale behind this multiplier is simple: over the term of the fund, by how much is the return larger than the investment.

COC (Cash on Cash Return). The annual return on the actual investment (the actual cash flow). In addition, this term can be treated as an estimate of the payback period. For example, if the COC return is 25%, it will be possible to recoup the investment within four years.

J Curve. Since the first years in new investment funds are “investment” years, with the fund manager looking for potential investments, the total cash flow in the first years is negative, but once the investments start generating income, the cash flow changes and become positive, resulting in the J Curve.

Distribution Waterfall.
In a PE investment, the distribution waterfall is the method by which the capital accumulated by the fund is allocated between the limited partners (LP) and the general partner (GP). The method takes into account parameters such as IRR, Preferred Return/Hurdle Rate, Private Equity Carry, and the Catch Up Mechanism, which are explained later in the article

There are 2 main types of distribution waterfalls: European and American. When calculating distributions, the European model is based on all fund transactions, whereas the American model allows for the distribution of profits to the fund manager, starting from the first transaction, known as Deal-By-Deal.

Preferred Return/Hurdle Rate. The minimum profit rate that the fund manager undertakes to pay the investors (LP) per year (the r – range is between 5%-8%), before the fund manager himself (GP) can receive fund profits (Carry).

Private Equity Carry. The fund manager’s standard profit model. This is usually a standard 2/20 structure, i.e. 2% management fees and 20% on all profit above the Hurdle Rate. There are, of course, other ratios.

Catch Up. A mechanism[4] to determine that all profits generated by the fund from the date that the fund manager has surpassed the HR will be allocated to the general partner until a pre-determined profit rate is obtained, after which profits will be allocated according to the fund’s Carry mechanism.

Catch Up example:

The Success fee is 20%, HR is 10%.

Total proceeds (after recouping the investment principle) – 100 million.

First stage: Payment of the minimum profit (HR) that the fund manager undertakes to pay to the investors (LP): 10% is 10 million.

Second stage: The fund manager (GP) will receive an amount that generates a profit of 20% of the total proceeds already distributed: that is, 2.5 million (10*0.2/0.8).

Third stage: The balance of proceeds (100-10-2.5=87.5) is distributed pro-rata (20/80), such that LP is 70 million, GP is 17.5 million. The total proceeds are distributed 20/80. LP – 80, GP – 20.If the CU clause did not exist, the distribution would be a little different: the first 10 million are distributed to the LP and the balance (90 million) is distributed pro-rata. The final result is 18/82. LP is 10+72=82, GP is 90*0.2=18.

The General Partner’s capital investment. Usually the general partner invests only 1% to 5% of the fund’s total assets. Here we see how the general partner’s return on capital is higher than the return on capital of the entire fund and of the limited partner. If we refer to the example in Section 7, and assume that the fund’s total investment was 100 million, and the general partner invested 5%, being 5 million, we see that the general partner’s income is 20, which equates to 4 times the investment.


By Alexander Elkin, Manager, Advisory Services


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[1] A limited partnership is a form of incorporation for business purposes in which there is the general partner, usually responsible for the ongoing management of the entity (GP), and the limited partner (LP), which enjoys the partnership’s profits in proportion to its investment but is not involved in ongoing management or in being a guarantor to the partnership’s liabilities.

[2] This is usually a private equity firm whose main activity and expertise is in managing private funds.

[3] Limited Partnership Agreement

[4] There is a full or partial catch up. Full (fast) means that during the entire CU period all profits go to the fund manager, whereas in the partial (slow) catch up, profits are divided between the fund manager and the limited partner.