FAQs of When Considering Your First PE Investment

Private Equity graphic
By Cooper Eral

Private Equity (PE) is a complex and intriguing realm of investment that often raises many questions for those considering it. As you contemplate the prospect of a PE investment, you’re likely to encounter a myriad of questions that delve into the intricacies of how PE firms operate, generate returns, and conduct their business. To help you navigate this world of PE investment with confidence, this blog aims to address some of the most frequently asked questions regarding private equity. We will demystify the process, explore the strategies that PE firms employ, and provide you with a comprehensive understanding of what to expect when considering PE as an investment avenue.

How do PE firms generate returns for their investors and themselves?

Private equity funds primarily generate income for themselves through what is known as 20 and 2. The 20 being “carried interest” and 2 being the “management fee”. This 2% is derived from the total committed capital and helps to sustain operations at the fund. The 20% is a crucial component in keeping the priorities of the fund and its Limited Partners aligned.  With 20% being the primary source of returns to the fund, it encourages its agents to source deals and grow companies with the greatest returns.

Do I receive dividends from profitable portfolio companies or are they used elsewhere?

Unless explicitly laid out in an investor subscription agreement, this is largely left to the discretion of the fund.  If the firm feels dividends could be best reinvested and focused on growing the PortCo, they will be used in this way. Alternatively, the company may require more guidance rather than continual capital needs, in this case distributions would be made equally across LPs, following the 20% carried interest allocated to the fund.

How do PE firms conduct due diligence and valuation of target companies?

This can vary from fund to fund but all groups will consider factors such as financial, legal, operational, management, and ESG due diligence. Depending on the specific thesis of the fund there may be greater scrutiny over a particular area, whether to avoid risk or ensure their unique value-add aligns with the needs of the potential portfolio company. Similarly, smaller funds may determine it is best to outsource specific aspects of due diligence in areas where they are not particularly knowledgeable or if they are focused on other areas. This will be determined prior to the commitment of capital.

When will I need to provide the capital for my PE investment?

Depending on the opportunity you take advantage of, whether a Special Purpose Vehicle (both debt and equity format) or buy in to a fund, this will vary. For a SPV, all capital invested is collected up front as this contribution is going directly to a specific need of a portfolio company. On the flip side, when committing capital to a fund there are capital calls and an upfront drawdown. The upfront drawdown is often 10 – 20% of the total agreed contribution. Capital calls occur (typically) at predetermined periods throughout the designated life of the fund. These capital calls are often enforceable by law based on contractual agreements between limited partners and the fund.

What are the key terms and conditions of a private equity deal, such as equity stake, debt financing, governance rights, exit clauses, etc.?

    • Equity Stake

      This is the percentage of the company’s shares that the private equity firm acquires in exchange for its investment. The equity stake determines the ownership and control rights of the PE firm over the target company.

    • Debt Financing

      This is the use of borrowed money to fund a private equity deal, usually in the form of bank loans or bonds. Debt financing increases the leverage and returns of the PE firm, but also increases the risk and interest payments. The amount and terms of debt financing depend on the creditworthiness of the target company, the availability and cost of credit in the market, and the structure and covenants of the debt instruments.

    • Governance Rights

      These are the rights and obligations of the PE firm and the target company’s management regarding the strategic and operational decisions of the company. Governance rights can include board representation, voting rights, veto rights, information rights, consent rights, and anti-dilution rights. Governance rights aim to align the interests and incentives of the PE firm and the management, and to protect the PE firm from adverse actions by the management or other shareholders.

    • Exit Clauses

      These are the provisions that specify how and when the PE firm can sell its stake in the target company and realize its returns. Exit clauses can include put options, drag-along rights, tag-along rights, pre-emption rights, and redemption rights. Exit clauses aim to ensure that the PE firm has sufficient liquidity and flexibility to exit the investment at an optimal time and price.

How do private equity firms create value in their portfolio companies through operational improvements, financial engineering, strategic initiatives, etc.?

As the question suggests, this is one area where funds can delimitate themselves from others in the market. Funds such as Traction Capital’s Focus Fund I seek to help founders and management teams expand upon their current strengths while offering resources to build up their weaknesses. Traction Capital (TC) strongly believes in the fundamental ability of Entrepreneurial Operating System® (EOS®) to efficiently go about these transformations within a newly acquired company. Any area with needs beyond the scope of EOS will be advised by an internal member of TC who also is a seasoned entrepreneur with relevant experience.

How can I invest in private equity?

There are different ways to invest in private equity, depending on risk tolerance and financial objectives; here are some of the most common ways. (listed in order from most to least knowledge and experience required).

    • Direct Investing

      This involves investing directly in a private company or a private equity fund. This can require a large amount of capital, due diligence, and expertise.

    • Co-Investing

      This involves investing alongside a private equity fund in a specific deal or company. This allows investors to reduce fees and increase exposure to a particular sector or opportunity.

    • Fund-of-Funds

      This involves investing in a fund that invests in multiple private equity funds. This allows investors to diversify their portfolio and access different strategies and geographies.

    • Secondary Market

      This involves buying or selling existing stakes in private equity funds or companies from other investors. This allows investors to enter or exit the market at different stages of the investment cycle.

    • Publicly Traded Vehicles

      This involves investing in publicly listed companies that invest in private equity or operate as private equity firms. This allows investors to access the public market liquidity and transparency while benefiting from the private market returns.

    • Traction Capital Focus Funds

      While this is a form of direct investing, there is nothing typical about the investment Traction Capital makes. Beyond the deployment of capital, TC offers their expertise, resources, and network to maximize the growth potential of each PortCo. To get updates on how to get involved with Focus Fund II or sidecar options, reach out to Ellie at Ellie@tractioncapital.com to learn more!  

Considering Private Equity

A PE investment can be a rewarding endeavor, but it comes with its unique set of considerations and complexities. The questions covered in this blog are just the starting point in your journey to grasp the world of PE investments. As you explore further and consider your investment options, it’s vital to engage with trusted advisors, conduct thorough due diligence, and remain informed about the ever-evolving landscape of private equity. By understanding how PE firms generate returns, how dividends are distributed, the due diligence process, capital requirements, key terms and conditions, value creation strategies, and the various ways to invest, you’ll be better equipped to make informed investment decisions. Remember that the world of private equity is dynamic, and a well-informed investor is best positioned to navigate its intricacies and reap the potential benefits it offers.

 

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