Introduction To Private Equity & Venture Capital #2: The Nuts And Bolts of PE & VC Funds

Summary

This video script offers an insightful introduction to private equity and venture capital, explaining the life cycle of a private equity fund, from fundraising to investment and exit strategies. It delves into the mechanics of deal sourcing, the hands-on approach of private equity investors, and the crucial role of general partners (GPs) in managing relationships with limited partners (LPs) and portfolio companies. The script also clarifies key terms and fee structures, including the '2 and 20' rule, and discusses the importance of LPs in shaping the private equity landscape.

Takeaways

• 📈 Private equity and venture capital funds are vehicles for investing in companies at different stages of maturity, with venture funds focusing on early-stage startups and private equity funds on later-stage companies.
• 🔄 Private equity funds have a finite life, typically up to 10 years with the possibility of a two-year extension, and go through a fundraising period, an investment period, and a holding period before exits occur.
• 💼 The process of deal sourcing in private equity is extensive, with firms like Bridgepoint considering hundreds of opportunities and conducting due diligence on a fraction of those to make a handful of investments each year.
• 🛠️ Private equity is a hands-on business where investors not only provide capital but also operational experience to help grow and improve the acquired companies during the holding period.
• 🤝 The relationship between general partners (GPs) and limited partners (LPs) is crucial, with GPs having a fiduciary duty to act in the best interest of LPs and aiming to generate outsized returns.
• 🏢 The private equity firm structure includes a GP responsible for deal execution and a manager or advisor for day-to-day operations, with the GP often investing in the fund to align interests with LPs.
• 📊 Successful private equity firms typically raise new funds every three to four years, with fund sizes increasing as the firm's track record and market opportunities grow.
• 📉 The cash flow for LPs in a private equity fund follows a 'J-curve' pattern, with initial negative cash flow during the investment period followed by positive cash flow as exits occur and profits are returned.
• 💰 The standard fee structure in private equity is '2 and 20,' referring to a 2% annual management fee and a 20% profit share for the GP, with the latter being the primary incentive for GPs.
• 🚫 While private equity has improved its transparency in recent years, there are still concerns about hidden fees charged to portfolio companies, which may affect the overall fee structure's clarity.
• 🤑 The distribution of profits from exits involves first returning the LPs' capital, then paying a hurdle rate, followed by a catch-up period for the GP, and finally splitting the remaining proceeds 80/20 between LPs and GPs.

Q & A

What is the primary focus of this video channel?

The video channel is focused on private equity and venture capital, aiming to educate viewers about these topics.

What is 'dry powder' in the context of private equity and venture capital?

Dry powder refers to the capital that is reserved and available for investment by private equity and venture capital firms.

What is the typical lifespan of a private equity fund?

A private equity fund typically has a lifespan of up to 10 years, with the option to extend by another two years.

What is the first phase of a private equity fund's life cycle called?

The first phase is called the fundraising period, which is when the fund is initially raised.

How many investments does an average private equity fund make per year?

On average, a private equity fund makes about five investments per year.

What is deal sourcing in private equity?

Deal sourcing is the process of identifying and finding suitable companies that fit the investment mandate of the private equity fund.

What is the role of the General Partner (GP) in a private equity firm?

The General Partner (GP) is responsible for managing the relationships with the Limited Partners (LPs) and the portfolio companies, as well as executing the deals and ensuring fiduciary duty towards the LPs.

What are Limited Partners (LPs) in the context of private equity funds?

Limited Partners (LPs) are the investors in the private equity fund whose liability is limited to the amount of capital they have committed to the fund.

What is the typical fee structure for private equity funds, often referred to as '2 and 20'?

The '2 and 20' fee structure refers to a 2% annual management fee on committed capital and a 20% profit share, known as carry, for the GP.

What is the J-curve in private equity and what does it represent?

The J-curve represents the typical cash flow pattern for LPs in a private equity fund, where initial negative cash flows (due to investments) turn positive as investments are exited and returns are realized.

How are profits distributed in a private equity fund after an exit?

Profits are first used to return the LPs' initial investment, then pay a hurdle rate (usually 8-10%), followed by catch-up for the GP, and finally splitting the remaining profits 80/20 between the LPs and the GP, respectively.

Outlines

00:00

💼 Introduction to Private Equity and Venture Capital Funds

This paragraph introduces the video's focus on private equity and venture capital, emphasizing the need for a shared understanding of terminology. It provides a brief overview of the private equity and venture capital market, including concepts like 'dry powder' and the mechanics of these funds. The speaker outlines the structure of the video series, with part one offering an overview and part two diving deeper into the functions of private equity and venture capital funds, their life cycle, and how they engage with private companies.

05:00

📈 The Life Cycle and Operations of Private Equity Funds

This section delves into the life cycle of a private equity fund, from fundraising to investment and eventual exit. It explains that private equity funds are closed-end funds with a finite life, typically up to 10 years with possible extensions. The process begins with fundraising, followed by an investment period where funds are deployed into private companies. The holding period, lasting between five to nine years, is when companies are grown and improved. The paragraph also discusses deal sourcing, the process of identifying suitable companies, and the significant effort involved in narrowing down opportunities to actual investments. The paragraph concludes by emphasizing the hands-on nature of private equity investors who actively contribute operational experience to the success of the acquired companies.

10:01

🤝 Key Relationships and Fund Structure in Private Equity

The paragraph discusses the critical roles and relationships within private equity, particularly focusing on the General Partners (GPs) and Limited Partners (LPs). GPs are responsible for managing relationships with LPs, who are the investors in the fund with limited liability, and with portfolio companies. The fiduciary duty of GPs towards LPs is highlighted, along with the importance of managing relationships with portfolio company management teams for future deal access. The structure of a private equity fund is outlined, including the roles of the GP, the manager or advisor, and the special purpose vehicle. The paragraph also touches on the process of raising successive funds and the growth of a successful private equity firm over time.

15:02

📊 Private Equity Fundraising and Cash Flow Dynamics

This paragraph examines the fundraising process for private equity funds and the cash flow dynamics for LPs. It explains the typical cycle of raising new funds every three to four years, contingent on the deployment of the previous fund's capital. The paragraph also describes the 'J-curve' of private equity cash flows, illustrating the initial negative cash flow during the investment period and the subsequent positive cash flow as investments are exited. The fee structure, commonly known as '2 and 20'—referring to a 2% management fee and a 20% profit share for the GP—is detailed, along with the potential for additional fees charged to portfolio companies. The paragraph concludes by emphasizing the role of LPs in driving improvements in fee transparency and disclosure within the private equity industry.

💰 Exit Strategies and Profit Distribution in Private Equity

The final paragraph discusses the exit strategies of private equity funds and how profits are distributed. It outlines the process of returning capital to LPs, starting with the initial investment, followed by a hurdle rate, and then the catch-up period for the GP. The distribution of remaining proceeds from exits is typically split 80/20 in favor of the LPs, with the GP receiving the 20% as carry or profit share. The paragraph also mentions an upcoming part three that will provide a worked example of how carry works in the context of leveraged buyouts (LBOs), and it concludes with an invitation for viewers to subscribe to the channel for regular video lectures.

Keywords

💡Private Equity

Private Equity (PE) refers to investment funds that invest in private companies, or buy out divisions of other companies, with the goal of improving their financial performance and eventually selling them for a profit. In the script, PE is discussed as an investment vehicle that operates through funds with a finite life and goes through stages of fundraising, investment, holding, and exit, exemplifying the PE life cycle.

💡Venture Capital

Venture Capital (VC) is a subset of private equity that focuses on investing in early-stage startups with high growth potential. The script distinguishes VC from PE by noting that VC funds invest in startups and early-stage companies, while PE funds typically invest in later-stage, more established companies.

💡Dry Powder

Dry powder in the context of private equity and venture capital refers to the uninvested capital that funds have on hand and are ready to deploy. The script mentions dry powder as part of the overview of the PE and VC market, indicating the amount of capital waiting to be invested.

💡Fundraising Period

Fundraising period is the initial phase of a private equity fund's life where the fund raises capital from limited partners (LPs). The script explains that the fundraising period is crucial as it determines the capital available for the fund to invest in private companies.

💡First Closing

First closing is a term used to denote the initial point at which a private equity fund has raised a significant portion of its target capital and can begin investing. The script uses the term to illustrate the starting point of a fund's investment activities.

💡Holding Period

Holding period in private equity refers to the duration that an investment is held in a fund's portfolio before it is sold or exited. The script mentions a typical holding period of five to nine years per portfolio company, highlighting the long-term nature of PE investments.

💡Deal Sourcing

Deal sourcing is the process of identifying and approaching potential investment opportunities. The script describes how a PE fund, such as a mid-market European buyout fund, looks at hundreds of opportunities annually and narrows them down through due diligence to a handful of suitable investments.

💡General Partner (GP)

A General Partner (GP) is a senior partner in a private equity firm who manages the fund's operations and has a fiduciary duty to the limited partners. The script explains the role of the GP in managing relationships with LPs and portfolio companies, as well as their investment in the fund.

💡Limited Partner (LP)

Limited Partners (LPs) are the investors in a private equity fund whose liability is limited to the amount they invest. The script discusses the role of LPs as the providers of capital to the fund and their relationship with the GP, including the GP's fiduciary duty to them.

💡Portfolio Company

A portfolio company is a company in which a private equity fund has invested. The script uses this term to describe the companies that PE funds acquire stakes in, with the intention of improving their performance and eventually selling them for profit.

💡Management Fee

A management fee is a fee charged by the GP to the LPs to cover the operational costs of running the fund. The script mentions '2 and 20' as the typical fee structure in private equity, where '2' refers to the 2% annual management fee based on committed capital.

💡Carry

Carry, also known as carried interest, is the share of the profits that the GP receives from the fund's investments, typically 20% in private equity. The script explains carry as the GP's profit-sharing mechanism, which incentivizes the GP to generate high returns for the LPs.

💡J-Curve

The J-Curve illustrates the typical cash flow pattern of a private equity fund, showing an initial negative cash flow during the investment period followed by positive cash flow as investments are exited. The script uses the J-Curve to describe the LPs' cash flow over the life of the fund.

Highlights

Introduction to private equity and venture capital, emphasizing the importance of understanding the terminology and concepts.

Explanation of 'dry powder' and its role in the private equity and venture capital market.

Detailed description of the life cycle of a private equity fund, including fundraising, investment, holding, and exit periods.

The concept of closed-end funds in private equity and their typical lifespan of up to 10 years with possible extensions.

Process of deal sourcing in private equity, from initial opportunities to the selection of suitable investments.

The hands-on approach of private equity investors who bring operational experience to improve acquired companies.

Role of General Partners (GPs) in managing relationships with Limited Partners (LPs) and portfolio companies.

Fiduciary duty of private equity firms towards LPs and the impact on future fundraising efforts.

Fund structure of private equity, including the roles of LPs, GPs, and the manager or advisor.

The typical fundraising pattern of successful private equity firms, raising new funds every three to four years.

Cash flow dynamics for LPs in private equity funds, often described by the 'J-curve' effect.

Fee structure in private equity, commonly known as '2 and 20', detailing management fees and profit sharing.

The process of profit distribution, including the return of capital, payment of hurdle rates, and profit sharing.

The importance of transparency in fee structures and the ongoing efforts to improve disclosure to LPs.

The impact of the relationship between private equity firms and portfolio company management on future deal making.

The growth of private equity firms over time, building a family of funds with increasing sizes and success.

The potential for 'hidden fees' in private equity and the need for LPs to be aware and request improvements.

Transcripts

hello and welcome back if you've always

been intrigued by

private equity or venture capital then

this video channel is for you

but before we dive into the questions

that you may have

and some of the details we want to make

sure that

everyone is on the same page and

everyone speaks the same language

in part one of this introduction

i walked you through the brief overview

over the private equity and venture

capital market right now we spoke about

dry powder

and we touched a little bit on the

mechanics on the functioning on private

equity and venture capital funds

part two will focus exactly on that

what do private equity and venture

capital funds do

how do they execute it how do they gain

access to those private companies

and we will have a quick look over the

life cycle

of those funds let's move on

and let's start so let's understand a

little bit

more about private equity and venture

capital

funds the vehicles that actually make

those investments

whether they are in early stage

companies in startups

in which case their venture funds or in

later stage

more established companies in which case

their private equity funds

so let's have a look of the life cycle

of a private equity fund

so private equity funds are what we call

closed end funds what does that mean

that means they have a finite life

usually

up to 10 years but at times they have

the right to extend their lifespan

by another two years so

every private equity fund starts off

with a fundraising period

once the first closing has been achieved

meaning at least 60 to 70 percent of the

fund have been raised sometimes 50

we basically start with the investment

period

that means we have a first closing at

which point the private equity firm

can invest in private companies and

start

to deploy their funds we then talk about

the holding period

usually between five and nine years

per portfolio company and uh

by year three or four we usually will

see

the first investment ex the first exits

happen meaning invested companies are

being sold

now let's see what it starts with it

really all

starts off in private equity with deal

sourcing

what does that mean that means the

private equity fund

is looking for suitable companies that

fit

the funds investment mandate now a

private equity firm and i'm using here

a an example from bridgepoint a

mid-market european buyout fund

a fund will look at up to 800

opportunities per year that's quite a

lot

they may do preliminary due diligence on

150

so very quickly they will try to narrow

it down to suitable investments

then basically present about 35 of those

investment opportunities to the

investment committee

meaning the partners in the fund that

make the investment decisions ultimately

and then we'll do formal due diligence

on about 20 investments so there's

quite a quite a funnel

that that we're seeing ultimately on

average private equity funds will

make about five investments per year so

from 800 that are incoming

interest so that your deal sourcing team

has basically surfaced

to five deals ultimately done so it's

quite a bit of hard work involved on the

way from deal sourcing to deal execution

so the private equity process itself

is a simple business you buy whether you

buy

not minority or majority stake in a

private company

you grow the company you improve it over

that holding period that we talked about

right at the beginning

and then basically you sell the company

again

so obviously there's a lot more to be

said about it

so we don't we want to do justice to all

those private equity

firms out there whilst it appears to be

a simple business

there is a lot of heavy lifting

especially during the

growth period where those deals those

acquired companies

need to be made successful so you should

consider

private equity investors very very

hands-on players

who bring basically operational uh

experience

to the table that should ideally

complement that of the

management in the company they will

managed basically impact and will

single-mindedly

focus on the uh

the execution of their investment

mandate

so that is clearly a uh an opportunity

to uh to explore so

players in the private equity and

venture capital fund are important so

again it's back to language

let's try to to understand and get that

language straight which we will be using

basically in every further lecture so

gps gps are the general partner

meaning those are the senior partners in

a private equity firm

gps manage two key relationships

on the one hand they manage relationship

with their lp's

lps are the limited partners those are

investors in the fund

and they're called limited partners

because their liability is

limited to the money that they're

investing in the fund

but they're also managing the

relationship with their portfolio

companies

so what exactly does that mean towards

the lps

the private equity firms have a

fiduciary duty

meaning if in doubt they need to decide

in

favor or to the benefit of the lps

and they obviously have committed

to generate ideally outsized

returns for their lps if that is done

well

that will clearly impact future

fundraising so

if the relationship with the lps is

raised is done well

we will be raising many more future

funds after the first one

now with the portfolio company

the private equity fund will need to

manage the relationship with the

management team

that obviously is important because as

large as the industry is

nowadays it is still a pretty close

circle

so word will clearly get out if a

private equity firm

is not dealing in an appropriate way

with the management team

in a portfolio company so

managing the portfolio company

relationship well will

impact future deal making i.e will you

have access to future deals

now let's have a look at the generic

private equity fund structure

and just very high level so as we said

private equity funds are closed and

funds

usually raised for a period of 10 years

in those 10 years the lps will

in invest the money in the private

equity fund

and by the end of the 10 years they will

have returned they will have received

their funding back

their investments back ideally with a uh

with a positive return so the lps

invest in the fund they are called

limited partners because their liability

is limited

only to the capital committed to the

fund

the private equity firm the sponsor also

in some jurisdictions

will basically allocate a will create a

special purpose vehicle

also called a gp a general partner that

is usually staffed by

senior partners from the private equity

firm

the gp is responsible for the execution

of the deals

for deal sourcing and execution and

ultimately is also responsible

for uh the fiduciary duty towards the

the lps the gp will also

invest in the fund usually anywhere

between

three and seven percent it can be more

in

in very few funds but usually the gp

will invest in the fund

to align the interest between the gps

and the lps

the lp is called is so nicely skinned in

the game we'll come to the profit

sharing and the fee structure

in a little bit so there's a manager or

advisor

that is part of the private equity firm

which manages basically the day-to-day

business

deal sourcing reporting and so on so

basically

uh administrative functions in the

private equity fund

once this fund has been raised the fund

is basically

ready to invest in portfolio companies

like we saw about five investments per

year so

for each fund we will see private equity

firms do about

five uh to 15 investments

out of each fund now

this was one fund but what makes the

successful private equity firm

a pro successful private equity firm

will

after let's say 20 years be able to look

back

at a family of funds so

they will have raised fund number one

with their fundraising investment and

divestment periods

or exit period if you like um in

year three to four of fund one usually

we will see them raise

fund too in year three to four

of fun two we will see them raise fund

three

and so on usually this is determined by

the amount of funding left in the

predecessor fund

so as soon as about 70 to 80 percent of

the fund has been spent i.e investments

have been made

we will see that a successor fund

is being raised so let me recap that

private equity firms raise a new fund

every three to four years

once about 70 percent of the active fund

have been deployed

what drives the fund size usually you

will see that fund one was smaller than

fund two fund too far smaller than fund

three

again in a successful private equity

firm it usually is determined by the

target market

the number of opportunities that the

fund is expecting

uh to see in the coming five years

during the investment period

and basically also to some extent

basically

on the sweet spot of the of the private

equity firm meaning

what is our ideal deal size that we're

seeing out there

so now let's have a look at the typical

cash flow

on the lp side on the investors side

if you are an lp in a private equity

fund

what kind of cash flow what will your

cash flow look like

over the 10 year life span of the fund

we referred to this as the j-curve

and as you will see during the first

five years

which is basically our investment period

you will see basically a negative cash

flow

the dark green line here is the

cumulative net cash flow

that the lp will see that means we will

see what we call so nicely

drawdowns the private equity firm will

basically call for capital

if and when they are ready to if they

found a suitable investment

and are ready to deploy from year six

onwards then we will see the j curve

later sticking up

because we are starting to see exits

meaning

funding is flowing back to the lps

because

those portfolio companies are being sold

the moment the companies are being sold

the capital is not reinvested it is

being returned

to the lps with the respective profit

or compensating for the respective loss

now fee structure and private equity is

usually

casually referred to as 2 plus

20. so two being

the management fee two percent per annum

on capital committed dropping down to

about 1.2 percent

on capital investment as invested as

the money is being deployed so

management fee

is your first layer of fees secondly

the gp will receive in return

for its uh for the work that they're

doing the deal sourcing the deal

execution the management of the

portfolio companies

they will receive a 20

profit share also called carry

carry is basically the net profit

twenty percent of net profits that are

going to the gps

ultimately the two percent management

fee

is being paid annually to keep the

lights on

and on the gp site that means to pay for

office rent for

travel for yeah for staff

and so on but what the gpu really is

working for

is the 20 profit share

so we will come to that in a small

exercise that we'll do as

uh quasi part three later on when we

look at the uh

at the distribution of the carry in the

context of

lbos leveraged buyouts very often

we will talk about so-called hidden fees

fees that are being charged to the

portfolio companies

board fees holding off portfolio

companies directors fees advisor fees

and so on

so we will basically circle back to in

one of our later sessions

overall so the fee structure in private

equity

is not uh super transparent and private

equity

has improved the way they are reporting

back to the lps in the last couple of

years

nevertheless there's i would argue

there's still work to be done

in terms of disclosure but ultimately

it's the lps that's basically manage

what happens in private equity as they

are the ones that can

ask for improvement

so returning money to investors the

in when we talk about exits we

will here we mentioned carrie already

the profit share that goes to the gp

so how is basically the funding

distributed

so number one we have step one we return

basically

uh initially out of all the profits and

out of all the money returned

after we sold a portfolio company we

will first return

all the money to the lps the money that

the lps have invested in that specific

deal

we then will pay to the lps a hurdle

rate

meaning a preferred return so before the

gp receives its carry its profit sharing

the lp will need to receive a hurdle

rate means usually between eight and ten

percent

then in step three again always assuming

that there's still

funding available the gp will play

catch up meaning this gp will receive

everything that pro rata that d the

lp has received in step one and two and

once there's more funding left we will

ultimately split

all the remaining uh proceeds from

a from an exit 80 20.

80 to the lp's

80 will go to the lp's 20

will go to the gps that's my carry

so ultimately at the end of the fun life

as well

that's how the math will be working out

so we will have a part three where i

will step you through a worked example

on how carry works for those of you that

like to

dive deeper and uh i would like to thank

you very much

for joining me again and i look forward

if you like this session then

please subscribe to the channel i will

be posting

videos video lectures on a regular basis

usually on a weekly basis thank you very

[Music]

much

you