Private equity is a type of alternative investment that involves investing in privately held companies. For most investors, private equity investing is accomplished through illiquid, long-term partnerships, also referred to as funds that are formed by private equity firms. Funds are generally closed end with 10-15 year lives, which require investing with a long-term horizon.
In layman terms, Private Equity fund is like any other fund where money or capital is collected from various investors and combined together to invest into real estate, equity, bonds and other funds or products for growth of the capital.
It has a very organized way of deciding how much money can be collected by an investor, collecting money in parts, most commonly based on percentages, investing money into products with the knowledge of money invested into each product by every single investor, and then selling those products at the right time to get maximum benefit for the investors and also for the company managing the private equity fund. When the funds a sold off, the profits are distributed between the investor and private equity company in a ratio (most commonly seen to be 80:20).
It appears to be simple mathematics when looking at the above process. But this process has various complexities and exceptions. Let us understand a few simple terms so that it becomes simple to understand the operations of Private Equity industry going ahead.
Capital Commitment - The maximum amount promised by an investor to invest in this fund.
Capital Contribution - The amount that the investor has invested so far.
Limited Partner (LP) - Another name of Investor
General Partner (GP) - The trustee, Asset Management Company or Private Equity Company itself.
An investor commits a maximum amount that he will invest throughout the life of the fund. That becomes his capital commitment amount and the total capital commitment amount of all the investors makes the total capital commitment amount for the fund. It is not mandatory for the fund to ask from the investor and invest all the amount that he has committed.
Now to start with the fund, a contribution amount is decided, that will be drawn down (taken) from each investor. It depends on the expenses of the fund (salary, brokerage, etc) and also on the investment opportunities available at that time. It is generally a percentage (10% to 40%) of the capital commitment amount. From the day money is contributed into the fund, a preferred return (interest) keeps accumulating in the fund that is to be returned to the investor before any other profits are shared between the investor (LP) and the private equity company (GP). i.e. If I invest $10 into a fund whose value becomes $17 after 2 years and whose PR (interest rate) is 10% on a non cumulative basis. When the money is realized by selling the products, first I will receive my $10, then the 2 years of non cumulative interest on $10, i.e. $2, and then on the remaining $5 profits a sharing between the company and me will be done.
I will try and not make it too complex at the beginning. Lets start with a few simple concepts and learn with the help of examples and tables to understand the operations in a private equity company in detail.
