Archive for the 'Investing in Private Equity' Category

Strategy and Due Diligence for Private Equity Investments

When considering an investment in private equity, investors need to consider a number of factors.

  • Can a small investor obtain the diversification needed
  • Does the investor have liquidity needs that would prohibit tying up funds for 7-10 years
  • Will the investor be able to fund promised commitments to the private equity fund when called for
  • What mix of sector, stage and geography is required to provide the best diversification

In addition, selecting managers requires special due diligence considerations:

  1. Can the investor and manager evaluate prospects for market success
    • Understanding of the markets, competition and sales prospects
    • Experience and capabilities of management team
    • Management’s commitment – ownership, compensation structure, etc
    • Opinion of customers
    • Identity of current investors – do they have particular expertise that lends confidence to outsiders
  2. Operational review
    • Have experts validated the technology
    • Consideration of employment contracts
    • What intellectual property rights have been established
  3. Financial and legal review
    • Potential dilution of interest
    • Financial statement (or tax returns, or investor-conducted audit)

Posted on 27th November 2008
Under: Active Management, Alternative Assets, Asset Allocation, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

The Role of Private Equity Investments in a Portfolio

Private equity investments typically have a low correlation to the returns on stocks and bonds, which provides a diversification benefit. Investors should understand, however, that the use of appraisals can result in a stale valuation and could partially explain the low correlation. If annual returns are used for both private equity and traditional assets, the correlations appear higher.

Although the risk reduction benefits may be modest, the expertise required to invest in private equity usually results in a higher return on investments. Therefore, a modest inclusion in the portfolio may still be merited.

Posted on 27th October 2008
Under: Alternative Assets, Asset Allocation, Institutional Investing, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

Benchmarks for Private Equity Investments

Benchmarking the returns of private equity investments is complicated by the fact that events that would indicate a change in market value (such as a new financing, acquisition, IPO, or failure of the business) occur infrequently.

Cambridge Associates and Thomson Venture Economics provide overall indices for VC and buyout funds. They typically calculate the internal rate of return based on cash flows since fund inception. Often firms are compared by vintage year for comparability across the stage of financing and any macroeconomic influences.

Since the venture capital must provide appraisals of some assets, stale valuations can result in a smoother return appearance than is actually realized.

Posted on 27th September 2008
Under: Active Management, Alternative Assets, Institutional Investing, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

The Structure of Private Equity Funds

Private equity funds are typically structured as limited partnerships or limited liability corporations (LLCs). There are a number of reasons for this preference.

  • No double taxation (profits taxed at limited partner or shareholder level)
  • No liability beyond the initial investment

Typically private equity funds will be structured to have a 7-10 year life, with options to extend this for an additional 1-5 years. The objective is to realize the full value of investments by the liquidation date. Rather than manage pools of uninvested capital, private equity managers typically require commitments that are drawn down as the funds are needed to make investments or cover expenses.

Fees for private equity managers typically include a management fee of 1.5% – 2.0% of assets under management, plus an incentive fee of 15%-20% of the profits retained after capital is returned to the limited partners. The incentive fee may include a hurdle rate of return that must be met before the fee is earned, and also may include a claw-back provision in case later investments do poorly.

Posted on 27th August 2008
Under: Active Management, Alternative Assets, Institutional Investing, Investing in Private Equity, Portfolio Management, Securities Regulation | No Comments »

Use of Convertible Preferred Stock in Venture Capital Invesments

Venture capital investors typically receive convertible preferred stock when funding companies. If the company is forced to liquidate, the preferred shares will have precedence in receiving funds. The company founders will hold a residual stake of common shares. If subsequent funding rounds are provided, each round is typically senior to the previous.

Typically the preferred investors must see a return of capital and also some investment return (often a total of 2x the capital contributed) before any cash can be returned to common shareholders. This provides the founders with an incentive to earn the return required by their investors so they can reap their own rewards.

The preferred shares are also convertible to common shares, which is typically done when a corporate action (merger or IPO) creates liquidity for the common shares and an opportunity to cash out.

Posted on 27th July 2008
Under: Active Management, Alternative Assets, Institutional Investing, Investing in Private Equity, Portfolio Management | No Comments »

Buyout Funds

Buyout funds represent a significantly larger market segment within private equity compared to venture capital. Mega-cap buyout funds typically will take public companies private through a leveraged buyout. Mid-market funds will purchase private companies or divisions of larger companies.

Buyout funds add value by restructuring operations, by buying opportunistically when companies are selling at less than their intrinsic value, or by capturing gains by adding to or restructuring existing debt. They can realize these gains through a later public offering, selling the company to another buyer or by recapitalizing (borrowing and using the proceeds to pay a special dividend).

Buyout funds differ from venture capital funds in a number of ways:

  • They are usually highly leveraged
  • Cash flows to investors are typically more stable and start sooner
  • Returns are not as subject to measurement error

Posted on 27th June 2008
Under: Active Management, Alternative Assets, Asset Allocation, Institutional Investing, Investing in Private Equity, Portfolio Management | No Comments »

Investments in Venture Capital

Formative stage companies and privately held companies often have limited access to capital. Start-ups often need capital to fund research or obtain office space before they have generated any revenue. Other companies may need capital in order to expand operations.

Venture capital can be supplied by Angel investors (accredited investors who supply small amounts of seed or early-stage capital), venture capitalists (who manage pooled capital and also offer companies financial and management support) or large companies who want to become strategic partners.

Financial needs for private companies typically go through several stages:

  1. Early stage financing
    • Seed capital – small amounts of money used to form the company and prove the idea
    • Start-up – pre-revenue commercialization of a product
    • First stage – additional funds that may be needed, and which are typically supplied only when conditions warrant
  2. Later-stage financing offers funds to promising companies that need to expand their operations
  3. Exit stage
    • Acquisition by a larger company
    • Merger with another company
    • Initial public offering (IPO)

Posted on 27th May 2008
Under: Active Management, Alternative Assets, Asset Allocation, Institutional Investing, Investing in Private Equity, Portfolio Management | No Comments »

Investments in Private Equity

Private equity investments are investments made in companies that are not publicly traded. They can take a number of forms:

  • Financing of private businesses by venture capitalists
  • Leveraged buyouts of public companies
  • Investments in distressed debt
  • Financing public infrastructure projects

Characteristics of private investments include:

  • Illiquidity (lack of a secondary market)
  • Requirement of long term commitments
  • Higher risk relative to public equities
  • Need for a high internal rate of return (25-30%)
  • Limited information availability, particularly for venture investments in novel technologies

Posted on 27th April 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investing in Private Equity, Investing in Stocks, Portfolio Management | No Comments »