Private Equity Funds - Essay Example

? Private Equity Funds Introduction Private Equity is the source of capital that is raised outside the public equity market in order to make investment in any asset or organization (Yong, 2012). The funds raised from the private equity market are generally sourced from those investors who are known as ‘limited partners’ which are then assigned to the respective investments with the help of the fund managers (also called ‘general partners’). These types of funds have huge difference from the other investment funds from the perspective of the business strategy used for seeking control over the businesses where they have invested (Cumming, 2009). These types of funds are also different in their structure because they are generally close-ended and have finite life time. The private equity funds have fixed number of shares. Private Equity Firms Nowadays, the leveraged buyout investment companies are referred to as the private equity organizations (Stowell, 2010; 2012). These types of firms are different from the venture capital firms which invest in emerging and young companies and as a result are not able to seek the majority control (Cumming and Johan, 2013). The emergence of private equity firms arose from the leveraged buyouts. The leveraged buyouts started during the 1980’s (Kaplan and Stromberg, 2009). The leveraged buyouts had increased rapidly in this decade and gradually the leveraged buyout companies became dominant corporate organizations. The private equity firms have been defined as the decentralized organizations with relatively fewer numbers of employees and investment professionals. Big private equity firms are larger in size but smaller than the firms where they make the investments. The funds raised by these private equity firms are known as the private equity funds. As already discussed above, these private equity funds are close-end products where the investors make commitment of providing a certain amount of money for making investments in various companies along with paying management fees to these private equity companies (Athanassiou, 2012). From the legal point of view, these funds are pre-arranged as the limited partnership arrangements where the limited partners offer majority portion of the capital and the general partners have the responsibility of managing these funds. The limited partners are the institutional investors like, the public and corporate pension funds, insurance companies or other wealthy investors. Now the question arises whether the private equity companies are the limited partners or the general partners. These firms act as the general partners of the fund. It is compulsory that the general partners provide at least one percent of the total amount of capital. However, some general partners invest even higher. These private equity funds have definite or fixed lifetime that ranges from 10 to 13 years. The private equity firm has a time period of five years, for investing the total capital to be funded to the companies and then, an additional time period of another five to eight years, for returning the total capital amount to the investors. After providing the capital amount, the limited partners do not have much to say about how the general partners would be deploying the investment funds, till the basic contents of the actual fund agreement are followed by these general partners. The basic contents of the fund agreement include restraints on the amount of fund capital that can be invested in one particular company, types of securities where the fund can be invested and restraints on the debt amount. The general partner i.e. the private equity firm, are generally compensated in three different ways. Firstly, these general partners incur a management fee as a percentage of the total capital committed followed by a percentage of the total capital employed, after the investment amount is realized. Secondly, these firms also incur one portion of the profit out of the fund which is known as the ‘carried interest’. The carried interest equals to 20 percent of the total portion of the fund. Sometimes these partners also obtain monitoring and other agreement fees from those companies where they make investments. The general partners also charge monitoring and deal fees to the portfolio organizations. Then, a portion of the total fees that has been collected is paid to the limited partners. Generally, when there is a common agreement between both the partners, then it ends up in a 50-50 sharing between the limited partners and the general partners. Private Equity Fund Transaction In this kind of transaction, the private equity firm makes an agreement of purchasing a company. If the company being purchased is public, then the private equity firm has to pay a premium amount of 15-50 percent on the existing stock price. This payment is financed almost 60-90 percent with the use of debt and is therefore, known as leveraged buyout. The debt bears one loan amount which is secured as it is arranged by the investment bank or another bank. During the 1980s or 1990s, these banks used to be the primary sources or investors in these types of loans. In last few years, the institutional investors purchase one huge portion of secured loan. The investors generally include the ‘collateralized loan obligation managers’ and the hedge fund investors who perform the task of combining various term loans into the pool and then, segregate the pool in different pieces in order to sell them to the institutional investors. The loan in these leveraged buyouts also includes an unsecured portion, which either gets financed by the yield bonds or the mezzanine debt. Importance of the private equity funds during global crisis The private equity funds play a significant role at the time of global crisis. These funds have made huge contribution during the crisis period by increasing the pace of its spread all over the world. The primary objective of the private equity firms is investing in the equities of the various unlisted companies for generating profits from the holding stocks of any one particular firm in the organization and then, distributing this amount among the investors. The private equity management of the portfolio firm performs the function of improving the performance of the organization so that the stock price rises significantly. Then, the private equity fund incurs profit by means of exiting the firm either by direct sale or by initial public offerings of the stock. International Private Equity Market The interest of the general public related to making investments in private equity market grew rapidly as the private equity investment yield much higher returns as compared to any other type of investment. The growth of this private equity market has increased rapidly in the recent years as these private equity funds act as the intermediaries, raising the demand of such investment among common public. On one side remains the investors, whereas on the other side, remains the issuers of those securities (Van den Berg, 2007). It has been stated that almost 80 percent of the private equity investments are made by means of the intermediaries and only 20 percent are made by direct dealings with the issuers of such securities. The chart below represents some of the largest private equity investments during 2009 and the first half of 2010. Private Equity Regulations It has been argued that in order to hedge the investment funds, the private equity funds have been exempted from the financial regulations or frameworks imposed on the traditional investment drivers (Dolan and   Davis, 2000). One of the significant differences between the hedge funds and the private equity funds is that the private equity funds do not possess high risk to the financial system. The private equity managers always deal with knowledgeable and sophisticated investors who have the ability of understanding the risk stemming out of their investments. This is particularly reflected through the level or type of regulations in private equity funds. There are many arguments which claim that private equity funds are not risky. They are given as: The private equity depends highly on the long term capital and does not make investment in the liquid assets. It is due to this reason that the funds have increased security as compared to other investment vehicles (McCahery and Vermeulen, 2010). There is no requirement of selling the assets, at the time of reducing prices, for funding the redemptions of the fund investors because there are no specific redemption periods. This type of investment has low leverage as compared to other investment vehicles. The portfolio companies do not have deep interconnection with other players of the financial markets. Thus, it is unlikely for such an investment to undergo a series of losses resulting in the systematic risk. The private equity funds are highly diversified in multiple industries as a result of which they do not have exposure to any particular sector’s performance risk. As already discussed above, the private equity funds acts as significant sources of funds during economic recession, mainly for those companies seeking for venture capital, buyout financing, expansion capital or debt financing. Merits and Demerits of private equity ownership There are pros as well as cons of the private equity ownership. Economic theory suggests that the private equity ownership helps in aligning interests of the owners and the managers of the organization (McFall, 2007). Another benefit of private equity ownership is the way it utilizes the debt financing and the disciplinary effect that it entails. Higher leverage establishes regular interest payments that help in exerting regulation on the management of the organization related to the removal of resources, which could be used by the management for investing in negative NPV projects (Gregory, 2013). There are additional advantages of private equity ownership which creates and adds value in realizing the capital gain in a repetitive manner. The private equity investment provides huge opportunity. It allows making investment in the unlisted companies which are initiating their growth journey. The private equity firms are highly selective and spend their resources according to the potentiality of the companies, after proper understanding of the risks and ways to mitigate them. The managers would make all attempts to invest in that very company which has the correct characteristics of achieving growth. The private equity company makes investment in an organization to make it highly valuable over a series of years, before selling it to the buyer who would appreciate the value that has been created. Thus, the private equity companies can be said to be patient investors making the correct investment decisions at the correct time. A combination of transparent accountability in between the managers of the organization and the shareholders and the requirement for realization, implies that the incentive structure might link tangible values with the rewarding system directly. Such kind of transparent accountability techniques have a large number of advantages. It provides comfort to the potential lenders, thereby allowing investments that are to be leveraged. There are some disadvantages of private equity financing related to the debt financing process (Povaly, 2007). The capital gains on the private equity reflect the value added in the restructuring of the firm such as, increasing the revenues or raising the profit margins. These gains are generally determined by the skills of the general partner that are used in setting the strategy or introducing a new management system. There is also the functioning of deal leverage in some cases where the cost of acquisition falls with the increase of debt financing, thereby reflecting the increase in actual returns with higher leverage. Schell (1999) has argued that there are strong destabilizing impacts caused by the leverage, which might be over utilized at the time of loose credit conditions owing to the mispricing of the debt. A rise in the investor’s valuation of the comparable firms over the holding period of the private equity firm will also have an impact on the return, at the time of rising equity markets. At such situation, the private equity firms expect to earn profit only in case of holding investment in a company. The extent till which the private equity buyouts can help in giving long term outlook as compared to the other types of investments is also challenged. It is a known fact that making a company private keeps it out of public spotlight, but the private equity firms are always accused of short term decisions made to reduce costs, raise the prices and stabilize the cash flows for allowing fast sale at high profit. These actions would definitely be harmful in the long term perspective. Additionally, the incentive structure associated with the relationship in between the limited partner and the general partner has also been questioned with arguments on the principal agent problems. These problems generally arise because of the rising conflicts between the limited and the general partners. One example of the rising conflict can be that the general partners operate in multiple funds with highly competitive investment strategies. So, even if the private equity firms prefer allocation of investment to one particular fund, it does not serve the purpose of the limited partners. Conclusion Private Equity fund has been defined as the source of capital which is raised outside the public equity market for making investment in any asset or organization. As already discussed above, the funds raised from the private equity market are sourced from those investors who are known as the ‘limited partners’. These funds are then assigned to the respective investments by means of the fund managers, also called ‘general partners’. The leveraged buyout investment companies are mostly referred to as the private equity organizations. The difference in between the private equity organization and the venture capital organizations is that these venture capital firms make investment in immature or emerging companies and fail to seek majority control over them. As discussed earlier, these private equity funds are close-end products. In these types of investments, the investors make commitment of providing certain amount of money for making investments in various companies along with paying management fees to these private equity companies. The transaction, included in this kind of investment, is different as compared to the other transactions. In this kind of transaction, the private equity firm participates in an agreement of purchasing a company. Now the question arises why the transaction is known as leveraged buyouts. If the company being purchased is a public company, then the private equity company would have to make a payment of a premium amount of 15 to 50 percent on the existing stock price. The majority portion of this payment, which is almost 60-90 percent is financed with the use of debt and is therefore, known as leveraged buyout. The debt bears one loan amount which is secured as it is arranged by the investment bank or some other banks. The private equity funds have also played a significant role at the time of global crisis. These funds have made huge contribution at the time of the crisis period by increasing the overall speed of its spread all over the world. The primary objective of the private equity firms is to make investments in the equities of the different unlisted companies in order to generate profits from the holding stocks of any one particular firm and then, disburse this amount of profit among all the investors. It has already been assessed that the interest of the general public in making huge investments in the private equity market have grown rapidly, as the private equity investment yield much higher returns as compared to any other types of investments. The growth of this private equity market has increased rapidly in the recent years as these private equity funds act as the intermediaries raising the demand of such investments among common public. There are a many advantages of private equity ownership. It has been discussed earlier that the private equity ownership helps in the alignment of interests in between the owners and the managers of the organization. Another benefit associated with the private equity ownership is its procedure of utilizing the debt financing, followed by the disciplinary effect produced out of it. Higher leverage helps in bringing regular interest payments that help in creating or increasing the regulation on the management of the organization, which is related to the removal of resources that can be utilized by the management in order to make investments in negative NPV projects. However, the private equity ownership also has some disadvantages in it. It has been argued that there are strong destabilizing impacts because of the leveraged buyouts which might be over utilized, at the time of loose credit conditions due to the mispricing of such debt. An increment in the investor’s valuation of the equivalent firms over the holding period of the private equity firm will throw an impact on the return, at the time of rising equity markets. Although the private equity funding has some disadvantages, yet the overall positive impact of such mode of financing is very high. It is due to this reason that the investors have increased faith in this type of investment. It would help in much faster revenue generation for the smaller organizations participating in the fund portfolio as compared to the larger organizations. Thus, it increases the scope of growth of these small firms in a relatively faster speed. The growth rate of these smaller firms would also increase, thereby increasing their chances of earning high profit figures. It is expected that the demand of private equity investment will rise even further in future because of their ability to contribute during the crisis period. It would increase the reliability of the investors on them with time. This implies that the net impact of the leveraged buyout on the investors is positive and should be enhanced in order to bring economic stability within the investment structure. Reference List Athanassiou, P., 2012. Research handbook on hedge funds, private equity and alternative investments. Massachusetts: Edward Elgar Publishing. Cumming, D., 2009. Private equity: Fund types, risks and returns, and regulation. New Jersey: John Wiley & Sons. Cumming, D. J. and Johan, S. A., 2013. Venture capital and private equity contracting: An international perspective. Amsterdam: Academic Press. Dolan, P.D. and   Davis, C. V., 2000. Securitizations: Legal and regulatory issues. New York: Law Journal Press. Gregory, D., 2013. Private equity and financial stability of the Bank’s Markets. Bank of England Quarterly Bulletin Quarter 1, pp. 38-47. Kaplan, S. N. and Stromberg, P., 2009. Leveraged buyouts and private equity. Journal of Economic Perspectives, 23(1), pp. 1-35. McCahery, J. A. and Vermeulen, E. P. M., 2010. Corporate governance of non-listed companies. New York: Oxford University Press. McFall, J., 2007. Private equity: tenth report of session 2006-07. London: The Stationery Office. Povaly, S., 2007. Private equity exits: Divestment process management for leveraged buyouts. Berlin: Springer. Schell, J. M., 1999. Private equity funds: Business structure and operations. New York: Law Journal Press. Stowell, D., 2010. An introduction to investment banks, hedge funds, and private equity. Amsterdam: Academic Press. Stowell, D., 2012. Investment banks, hedge funds, and private equity. Amsterdam: Academic Press. Van den Berg, W. A., 2007. Private equity acquisitions. Amsterdam: Rozenberg Publishers. Yong, K. P., 2012. Private equity in China: Challenges and opportunities. New Jersey: John Wiley & Sons. Read More