Definition of private equity
Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange.
Types of private equity strategies
Private equity investments can primarily be categorized into 3 strategies: buyout, venture and angel investors.
Historically, NAXS has focused on buyout investments. 3 main characteristics of buyout investments are:
- majority control investments;
- targeting mature companies, usually with a positive cash-flow;
- typically involving the use of financial leverage.
Typical structure of a buyout fund
Buyout funds are typically structured as limited partnerships (similar to the Swedishkommanditbolag), although certain funds can be structured as limited companies (such as, in NAXS’ portfolio, the Valedo funds). The investors enter into a limited partnership agreement, under which they agree to provide a certain amount of capital to the fund and to pay fees to the private equity firm managing the fund. The private equity firms also invest in the funds they are managing, usually committing between 1-3% of the total capital.
Typical modus operandi of a buyout fund
- During the fundraising period, a buyout firm will be seeking capital from investors for its fund. The investors enter into a limited partnership agreement (in reference to the legal structure used by most buyout funds; the investors are also know as limited partners), through which they agree to pay a certain capital to the fund in connection with the fund making investments. The total amount of capital that an investor agrees to pay to a fund is called a commitment, and the total aggregate commitments to a fund represent the fund’s size. No capital is paid to the fund other than in connection with the fund making a specific investment, at which point the fund “calls” its investors for capital (such capital calls are also known as draw-downs).
Once a fund has reached its fundraising target, it will have a final close (the year a fund has held its final close is called the fund’s vintage year). After this point it is not normally possible for new investors to invest in the fund, unless they were to purchase an interest in the fund on the secondary market.
- A buyout fund typically has a duration of 10 years, during which time the investors’ commitments will be invested and paid back. The duration of a buyout fund can be divided into:
- an investment period, typically lasting 5 years, during which the funds make investments, i.e. acquires companies (the acquired companies are also calledportfolio companies);
- a development period, typically lasting from 3 to 7 years from the date of the investment, during which the fund develops and then sells the portfolio companies (the sale of an investment is also known as an exit).
- The main activity of a buyout fund during the holding period of the investments is to actively contribute to the growth and development of the portfolio companies, through the providing of capital and management expertise, notably through the board of the portfolio companies and the network of industry specialists linked to the fund.
- Typically, a buyout fund will offer the management of a portfolio company the possibility to become a shareholder in the company through an incentive program, thus aligning the interests of the fund and the portfolio company management.
- During the period a buyout fund holds an investment, the manager of the fund will provide periodic valuation of the investments (usually on a quarterly basis).
The fund pays back the investors immediately after an investment is sold, thus returning to investors the initial capital invested, plus any profit realized in the investment.
At the end of the duration of the fund, the fund is liquidated and ceases to exist.
- The fees charged by the manager of a buyout fund typically can be divided into two components:
- a management fee, which is intended to cover the management and running costs of the fund. Such fee is calculated as a percentage of the total commitments to the fund and, depending on the fund’s size, typically amounts to 1-2% per year;
- a performance fee, also called carried interest, whereby the manager receives part of the gains realized in the sales of the fund’s investments. The carried interest is subject first to the investors in the fund recouping the totality of the initial capital invested, plus a preferred return on their initial capital (the so-called preferred return, which usually amount to 8%). Once these amounts have been recouped, the manager typically retains 20% of the profits, while the remaining 80% are distributed to the investors in the fund.
Characteristics of buyout investments
Investments in buyout funds typically are long-term and illiquid investments:
- the period between which a fund has raised new capital and has fully invested it can be up to 5 years;
- portfolio companies are usually held by the fund for a period of 3 to 7 years;
- the investors do not receive any return on, or income from the capital provided to the fund until the fund sells an investment.