Private equity
6 min

How does a private equity fund work?

Institutional investors such as insurance companies, family offices or high-net-worth individuals (HNWIs) have been using private equity as an alternative to exchange-traded corporate investments for decades. According to a study by the consulting firm Ernst & Young, high-net-worth individuals already invest almost one-third of their assets in alternative asset classes - including private equity. Through special private equity funds, they invest in established companies - traditionally from the upper middle class. What exactly private equity funds are and how they work is explained in the following article.

Mona Feather

What is a private equity fund?

Before we go into how private equity funds work, let's briefly clarify what a fund actually is. You can think of a fund as a pool into which many investors pay their capital. Before the fund opens, the maximum amount of money that can be collected is usually defined. As soon as this limit is reached, the fund is closed. This means that no more money is collected.

The fund capital is then successively invested in various companies. The process is controlled by experienced fund managers. Compared to a broadly diversified share index (e.g. the MSCI World, S&P 500 or MDAX), the number of investments is much smaller - and so is the spread of risk. Investors should be aware of this before investing. PE managers also take an active influence on the management of their investments, whereas the classic fund manager at most makes use of his voting rights at the general meeting. The goal: the company is supported financially, operationally and strategically in order to achieve certain development and growth goals. This should increase the market value - and consequently also the return for the investors. The term of a private equity fund is between ten and twelve years.

Important note: A majority of PE fund investments fail. The capital invested can only be recovered to a limited extent (if at all). The performance of a PE fund basically depends on the above-average development of a few companies, which cannot be guaranteed ex-ante. Investors should be prepared for this potential total loss risk in their asset allocation - especially because investments are often financed with large amounts of debt capital. Due to the long capital commitment, an early exit is only possible at a high discount. Financially, this step is rarely worthwhile.

Phase 1: Identification of potential investment candidates

In the first phase, everything revolves around setting up the fund. During this time, the PE company develops the investment strategy, prepares pitch documents for potential investors and conducts fundraising for future investments. This phase can take months to years. The focus here is on communication with potential investors.

In addition, a deal pipeline is built up during this phase. In concrete terms, this means that PE managers analyse the market and identify interesting investments that fit the investment focus of the fund. This is also the most active phase of a PE fund. Companies have to be evaluated (due diligence), purchase prices negotiated and contracts concluded. Compared to a venture capital fund, PE funds invest in already established companies with a proven business model. VC funds, in contrast, focus on young start-ups, most of which are still in the product development phase.

The first phase is followed by participation in companies.

Phase 2: Participation & building market value

Once all legal and financial issues have been clarified, the transaction process is completed. In the next step, the fund managers focus on building up the market values and selling their investments as profitably as possible. Often, further investments in new companies are excluded by fund agreement (capital increases in active investments are excluded).

How exactly is the company value increased? PE managers actively influence company management. Private equity companies employ teams of experienced industry experts who are typically deployed on site in the respective portfolio companies. There they initiate efficiency and growth projects (e.g. internationalisation of business areas) and are available to the management at any time. The measures are not always successful. Many portfolio companies fail in this phase - but more on that in a moment.

This phase ends - depending on the company's development - on average after 4-6 years.

Phase 3: Sale of units and distribution to investors

How exactly does the return on a private equity fund come about? In principle, by selling companies at higher prices (compared to the original purchase price). The so-called exit can take place in different ways.

A popular option is the initial public offering (or IPO). In this case, all privately traded company shares become publicly available (on the stock exchange). The costs of an IPO should not be underestimated, which is why it only makes sense above a certain company size. Many companies such as Fielmann, Facebook, Beyond Meat or Airbnb have taken this step. 

Below we have summarised the most common exit methods for you:

  • Strategic acquisition (trade sales): In a strategic acquisition, a shareholding is taken over by a buyer who has a strategic interest in the company. Often this involves complementary or competing business models.
  • Secondary sale: In a secondary sale, the buyer is another PE company. The reason for this can be that a company needs more capital, which cannot be provided by the current PE company. Often, the targeted development stage has been reached.
  • Buy-back (BB): In a BB, the shares in the company are bought by the management. In doing so, they increase their stake in the company.
  • Liquidation: If the development of the investments was not successful, the investments contained in the fund are sold on a certain date. The fund is effectively dissolved. In this case, investors must expect financial losses.

Mona Feather
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