Private equity

Updated: 2006-10-19 09:07

Private equity is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. Categories of private equity investment include leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others.

Private equity securities
Private equity securities refer to securities in companies that are not listed on a public stock exchange; while technically the opposite of public equity they are broadly equivalent to stocks, though return on investment often takes much longer. As they are not listed on an exchange, any investor wishing to sell securities in private companies must find a buyer in the absence of a traditional marketplace such as a stock exchange. In addition, there are many transfer restrictions on private securities. This long term investment area currently has over US$710 billion in assets.

The sale of private securities is used by companies to generate capital. Investors generally receive their return through one of three ways: an initial public offering, a sale or merger, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.

Private equity funds
Although other structures exist, private equity funds are generally organized as limited partnerships which are controlled by the private equity firm that acts as the general partner. The fund obtains commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at which time each limited partner funds a pro rata portion of its commitment. All investment decisions are made by the General Partner which also manages the fund's investments (commonly referred to as the "portfolio"). Over the life of a fund which often extends up to ten years, the fund will typically make between 15 and 25 separate investments with usually no single investment exceeding 10 percent of the total commitments.

General partners are typically compensated with a management fee, defined as a percentage of the fund's total equity capital. In addition, the general partner usually is entitled to "carried interest", effectively a performance fee, based on the profits generated by the fund. Typically, the general partner will receive an annual management fee of 2 percent of committed capital and carried interest of 20 percent of profits above some target rate of return (called "hurdle rate"). Gross private equity returns may be in excess of 20 percent per year, which in the case of leveraged buyout firms is primarily due to leverage, and otherwise due to the high level of risk associated with early stage investments. Although there is a limited market for limited partnership interests, such interests are not freely tradeable like mutual fund interests.


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