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Private equity terms
by BVCA
Private equity
The term "private equity" is the term generally used in Europe
to cover the industry as a whole, both buy-outs and venture capital.
"Venture capital" is a subcategory covering the seed to expansion stages
of investment. Private equity describes equity investments in unquoted
companies often accompanied by the provision of loans and other capital
bearing an equity type risk.
Carried interest or carry
Equivalent to a performance fee, this represents the share of a private
equity fund's profit that will accrue to the general partners (also see
"Hurdle rate").
Committed funds or raised funds
Capital committed by investors. Cash to the maximum of these commitments
may be requested or drawn down by the private equity managers usually
on a deal-by- deal basis. This amount is different from invested funds
for three reasons. Firstly, most partnerships will initially invest only
between 80% and 95% of committed funds. Second, it may be necessary in
early years to deduct the annual management fee which is used to cover
the cost of operation of a fund. Third, payback to investors usually begins
before the final draw down of commitments has taken place.
Distributions
These are payments to investors after the realisations of investments
made by partnership.
Exits, divestments or realisations
Private equity investors generally receive their principal returns via
a capital gain on the sale or flotation of investments. Exit methods include
a trade sale (most common), flotation on a stock exchange (common), a
share repurchase by the company or its management or a refinancing of
the business (least common). Secondary purchases of the company by another
private equity firm are becoming an increasingly common phenomenon.
Draw downs
These are payments to the partnership by investors in order to finance
investments. Funds are usually drawn down from investors on a deal-by-deal
basis.
Funds of funds
These are funds whose principal activity consists of investing in private
equity funds. Investors in funds of funds can thereby increase their levels
of diversification.
Gatekeepers
These are specialist advisers who assist institutional investors in their
allocation decisions to private equity.
General partners
These are the private equity firms, who select investments, structure
deals, monitor investments and design the appropriate exit strategies
on behalf of the limited partners.
Hurdle rate
This is the minimum return to investors to be achieved before a carry
is permitted. A hurdle rate of 10% means that the private equity fund
needs to achieve a return of at least 10% per annum before the profits
are shared according to the carried interest arrangement.
Interim return
The final rate of return of a private equity investment can, by definition,
only be calculated when all investments are sold and the fund is wound
up. Most return calculations therefore produce interim IRRs which are
close to the final rate of return after approximately three to six years.
This convergence period is usually shorter for buy-out funds than for
early stage and development funds.
Internal rate of return (IRR)
The IRR method is the most appropriate method for calculating the returns
of a private equity fund. In essence, the IRR represents the rate at which
positive and negative cash flows are discounted so that the net present
value of the fund amounts to zero. It is not consistent with the time
weighted return (TWR) used for other components of a scheme's investment
portfolio and care should be taken in making comparisons.
Limited partnerships
In limited partnerships, institutional investors generally constitute
the limited partners and private equity firms act as general partners.
The minimum investment considered by many private equity firms usually
amounts to 1% of the total funds being raised. The maximum investment
usually accepted from a single investor corresponds to about 10% of the
total fund size. The majority of private equity funds include between
10 and 30 limited partners.
A limited partnership usually has a life fixed initially at 10 years during
which the general partners select investments, structure deals, monitor
investments and design the appropriate exit strategies on behalf of the
limited partners. The partnership's funds will usually be invested by
the general partners within three to five years. Despite being set up
with an initial life of 10 years, many funds continue to exist beyond
that period because some investments will not be fully realised within
the intended life of the fund. When all investments are fully divested,
a limited partnership can be terminated or "wound up".
Private equity funds
Managed by private equity firms who raise funds from external sources,
such as pension funds, insurance companies and others. There are over
200 such funds managed by BVCA members.
Secondary market
The secondary market enables investors to buy and sell stakes in private
equity funds whilst it is ongoing.
Trade sale
This is the sale of the equity share of an investee company to another
company.
Venture and development capital investment trusts
Quoted private equity funds that invest "a significant portion of [their]
...portfolio in the securities of unquoted companies" (definition: Association
of Investment Trusts). There are around 20 managed by BVCA members.