Private Equity. Explained!!

What is Private Equity?

Private Equity is an alternative investment class and consists of capital that is not listed on the stock exchange. Private Equity funds pool the money from HNIs, Sovereign funds, Institutional investors, and they invest in Private Companies. As they invest in Private companies, it is called Private Equity. Private Equity firms make money by charging management fees and performance fees from investors in a fund. Private Equity firms invest for a longer period i.e., from 7 to 10 years. They invest mostly in Startup companies. As they invest and take a huge stake in startup companies, they are also involved in the management of the company. They guide the management of the company to grow the company they have invested in. They develop the company, improve the profitability of the company and increase the valuations of the company and these Firms also help startups to get listed on Stock Exchange. Private Equity Funds are closed-ended funds and these investments are very risky investments, as the funds are invested in Startup companies and the capital is locked for 7 to 10 years. The capital raised by PE Firms can be utilized to fund new technology, make acquisitions, expand working capital, and bolster a balance sheet.

Why Private Equity?

Private Equity Funds provide a way to easily access alternate forms of capital for entrepreneurs and company founders. Most companies favor Private Equity because it provides them with access to capital as an alternative to conventional financial mechanisms, such as high-interest bank loans or listing on stock markets. In the case of companies that are delisted, private equity financing can help such companies adopt unorthodox growth strategies, which are away from the glare of public markets.

Investing in Private Equity Funds

Private Equity Investments primarily come from Institutional Investors, Sovereign funds, and accredited Investors who can dedicate a substantial amount of money for an extended period. Long holding periods are considerably needed for Private Equity Investments, to transform a distressed company into a company enabling liquidity events, such as IPO (Initial Public Offering) or sale to a public company.

Structure of Private Equity Funds

The structure of a private equity fund involves an onshore fund and an offshore fund.

Onshore Fund

If the fund is launched and domiciled in India, and also the investors in Private Equity funds are from India, then it is called an ONSHORE FUND.

Offshore Fund

This fund refers to the fund which is outside India. Offshore funds are mainly located outside India. Offshore funds come into the picture when a person from outside India wants to invest in an Indian Fund. For Example, if the main fund or onshore fund is located in India and the offshore fund is in Luxembourg and if any person from Pakistan wants to invest in India, then he can send money to the offshore fund. Then offshore funds can send money to the main fund or onshore fund. Offshore funds are mainly used to divert investments. Offshore funds came into the picture mainly because of geopolitical reasons and tax-related issues. Tax-related issues mean for example when a person from America wants to invest in an Indian fund, he has to pay tax on profits in India and America. But if the offshore fund is in Luxembourg, which is a tax haven country, and if the person from America invests in an Indian fund through the offshore fund (Luxembourg), then he need not pay taxes in two countries.

Understanding Private Equity

Private Equity Funds are generally registered as LLP (Limited Liability Partnership). There will be a General Partner and Limited Partner. General Partner is referred to as a Private Equity Firm that manages all the investment-related activity. Limited partners are Investors such as Public Pension Funds, Insurance companies, HNIs, Fund of Funds. General Partner deals with the investments of Limited Partners. General Partner liability is limited to the investments made by Limited Partners. So General Partner is registered as Limited Liability Company (LLC). Limited partners have unlimited liability. General Partners receive a management fee of 2% of the capital committed to investing in a fund. General Partners take management fees for managing the fund. General Partners also receive Carried Interest from investors, if the return from the fund exceeds a rate called Hurdle Rate. If the hurdle rate of the fund is 10% and the returns from the fund exceed 10%, then General Partners will be eligible for the Carried Interest also.

Waterfall Provisions

Ex: When the Private Equity Funds liquidate their investments after 10 years, the profits will be distributed between Limited Partners and General Partners in the ratio of 80:20.

Waterfall Provisions explain the procedure on how the profits are to be distributed between Limited Partners and General Partners.

The steps followed in Waterfall provisions are:

1. Return the initial capital to the Limited Partners

2. The preferred return of 8% should be given to the Limited Partners

3. Catch up of 20% of cash inflows to be distributed to General Partner

4. Then the remaining profits will be distributed in the ratio of 80:20 to Limited Partners and General Partners respectively.

For Example, Sequoia Capital, a PE firm raised 1000 crores from Investors. 950 crores invested by Limited Partners and 50 Crores invested by General Partner.

After 10 years Sequoia capital liquidated the investments and received 2500 crores.

1. 950 crores will be distributed to Limited Partners.

2. Preferred return of 8% (1000*8%) 80 crores to be distributed to Limited Partners.

3. Catch up of 20% (1470*20%) 294 crores to be distributed to General Partners.

4. 80% of remaining profits (1176*80%) 940.8 crores to be distributed to Limited Partners

5. 20% of remaining profits (1176*20%) 235.2 crores to be distributed to General Partners.

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