Private Equity Terminology
Private Equity, like most areas of finance, has plenty of terminology and technical jargon that may be confusing. Understanding these concepts, however, can go a long way towards understanding and decoding what practitioners in the industry are trying to say.
As a line from the hit 2015 film, The Big Short bluntly states, “…it’s pretty confusing, right? Does it make you feel bored or stupid? Well, it’s supposed to. Wall Street loves to use confusing terms to make you think only they can do what they do…” Of course, that’s a dramatized sentiment as most in the industry are not actively trying to confuse you, but we also recognize that people in the industry often use terminology that not all of us are familiar with. An important aspect of partnering with a specialist in alternative investments should be the guidance and educational introduction to strategies with which many investors are unaccustomed. This includes, of course, the private equity terminology used to characterize strategies such as venture capital, growth equity, and buyout.
Private equity is viewed synonymously with the term “Buyout.” What Buyout entails is very much evident in its name. A buyout is a transaction where an investor (often in the form of a private equity fund) purchases a controlling stake of an operating company, either public or private. Often, buyouts can be referred to as leveraged buyouts or LBOs. An LBO means that a significant portion of the purchase comes from debt. For example, say that a private equity manager is looking to purchase an operating company, such as a hotel for $1M. With an LBO, the private equity manager can put $400,000 of equity into the transaction and borrow the remaining $600,000 by issuing bonds on the hotel.
A vast majority of buyouts are control transactions, meaning in the private equity context, that a PE fund acquires enough equity to control the target company. In doing so, a PE manager can enact rapid changes to the strategy, personnel, or operations of a target company in order to help the company achieve operational efficiency and an improved sales trajectory.
Buyout Versus Venture Capital
Buyout may be viewed synonymously with private equity, but private equity spans an entire universe of strategies, including growth-equity and the ever-popular “venture capital”. A key difference between a traditional buyout strategy and a venture capital strategy is that a buyout strategy will typically target mature operating companies, whereas venture capital funds target startup companies.
A startup company, by definition, often does not have revenue, cash flow, or any sort of substantial assets. Because of the lack of collateral available, most banks typically won’t lend to a startup company (hence venture capital’s opportunity). This differs from a buyout strategy where target portfolio companies are mature, generating revenue/cash flow, and have a significant asset base (many times including patents, property, and equipment) that can serve as collateral to the bank loans. You can learn more about this landscape of company lifecycle and what types of funds invest in them in our piece Bearing Fruit from Private Equity: The Difference Venture Capital and Growth Equity.
Private Equity Landscape in the Business Cycle Framework
Source: Crystal Capital Partners - The Difference Between Venture Capital and Growth Equity
Across the private equity landscape, we often hear that the industry is flush with “dry powder.” Dry powder refers to the amount of cash commitments, in the form of uncalled capital, that a fund can invest in new assets. Dry powder can be seen as a barometer for deal activity, as a manager with high amounts of dry powder, or cash, available is expected to deploy that capital. As of 2021, private equity has record amounts of dry powder according to reports, indicating there is more capital to be deployed from the industry than ever before.
Source: Prequin - What Private Equity's Record Dry Powder Haul Means for the Industry
The concept of “uncalled capital”, discussed in the last section, leads into another private equity terminology that is often used in the industry and important to understand. Private equity strategies are inherently “drawdown” vehicles, meaning investors make a commitment to provide capital to the fund after the fund manager identifies investment opportunities. The capital that an investor commits to a fund but is not yet required to provide is known as “uncalled capital”. When investors are “called” to provide capital as investment opportunities become available or as required by the fund, the “called capital” is the money that investors must deliver to these funds. This process is also known as a drawdown, which refers to the drawing of capital from reserves over time.
The j-curve represents the shape of an expected return stream in a private equity fund over the life of the fund. The j-curve is a result of funds charging fees on committed rather than invested capital. When a fund is in its investment period, the fund manager charges fees before the capital is put to work. Sending money to the fund manager for fees and fund expenses before any investments are made will inherently create an early return drag for investors.
Source: Allen Latta - LP Corner: The J-Curve
Despite the early return drag, the returns are expected to pay off in the long run when the private equity fund is fully deployed. Due to the maturation and competitive fundraising environment, some private equity funds will only charge fees on invested capital. Having said that, the top fund managers are expected to continue to charge based on capital commitments due to high demand for their funds. Another practice managers may use to mitigate the j-curve is utilizing what is known as a capital call facility.
Capital Call Facility
A capital call facility is a line of credit against the subscriptions to the fund. It is provided by banks to private equity firms and allows them to manage capital calls by allowing them to access capital immediately, while calling the capital from their investors at a later date. By calling upon investors’ capital later in a fund’s life cycle, the private equity firm can effectively improve fund IRRs.
What About My Money? Understanding Irr And Moic
And naturally, explaining this lingo only begets more lingo; this time it’s “IRR” and “MOIC”. Knowing the meaning of these performance indicators and how they are used in the industry is a critical part of this journey to better understand the importance of private equity terminology.
IRR is a popular measure of how the investor’s capital is performing. IRR stands for Internal Rate of Return and is the annualized rate of return from a series of cash flows relating to the particular investment (in this case a PE investment). IRR considers when the investor pays money in, and when an investor receives a distribution from their investment. For investments that are still active, the IRR calculation will also take the current value of investments still held by the Fund and assume that they are distributed at their current mark. Investopedia notes that “Generally speaking, the higher the Internal Rate of Return, the more desirable an investment is to undertake.”
Annualizing doesn’t explain exactly what happens when you put $1 into the investment, or what that dollar is now worth. That number is better seen using a different metric, known as “MOIC.” MOIC, or Multiple on Invested Capital, is a simpler return metric that focuses on an investment’s current value versus the amount of money initially invested. A simple way of viewing this: if you invest $1 million and the asset you purchased is now worth $1.5 million, your MOIC is 1.5.
Source: Investopedia - Internal Rate of Return (IRR)
Carried Interest & Other Pe Fees
Of course, the manager isn’t doing all of this for free. In the previous example, your $1 million becoming worth $1.5 million makes a “gross” MOIC of 1.5, meaning that your value hasn’t been adjusted for fees, carried interest, or other fund expenses. Understanding a 2% management fee is easy enough, but you may now be asking yourself what “carried interest” means.
Carried interest is sometimes referred to as a “performance fee,” “profit participation,” or simply just “carry.” It is the share of profit that the PE manager earns depending on the amount of profit they return to their investors. In private equity, this is typically between 20-30% of profits, but is subject to a “preferred return/hurdle,” meaning that the fund manager does not get to participate in any profits until the investors receive a return of at least that preferred amount, often 8% or above.
There may be other private equity fees to be aware of on top of management fees and carried interest, such as closing and administrative fees. It is important to understand that no two private equity funds (or investors) are exactly the same, which causes fee arrangements to vary widely and creatively. Managers must be transparent with their fees, and investors are entitled to fully understand the fee arrangements they are agreeing to pay as part of their investment.
In many private equity funds, there is a protection in place for investors known as the “GP Clawback.” If a PE fund manager (the “General Partner/GP”) is paid too much carried interest over the life of a fund, which can depend on the overall performance of the fund, then they will have to pay that excess amount of profits they’ve received back to the investors. Typically, the clawback occurs at the end of a fund’s life, as it is difficult to evaluate the complete and final amount of value a GP is entitled to receive until the fund has been fully realized and investors have their final amounts of investments plus profits paid back to them.
While this piece only covers some key private equity terminology and is not an exhaustive list, those interested in the private equity industry can begin to build a foundation with these concepts. There are many terms used within the world of finance, and the universe of private equity, to educate ourselves and help us understand how the industry operates day-to-day.
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