Introduction To Private Equity & Venture Capital #2: The Nuts And Bolts of PE & VC Funds
Summary
TLDRThis 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
💼 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.
📈 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.
🤝 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.
📊 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.
Mindmap
Keywords
💡Private Equity
💡Venture Capital
💡Dry Powder
💡Fundraising Period
💡First Closing
💡Holding Period
💡Deal Sourcing
💡General Partner (GP)
💡Limited Partner (LP)
💡Portfolio Company
💡Management Fee
💡Carry
💡J-Curve
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
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