In Private Equity Jargon Explained: Part A we explained the terminology surrounding the types of private equity funds, types of investments and stages of investment. Now, following on from Part A we will look at fund structures, returns & distributions and selection criteria.
Open-end funds
Open-end funds allow investors to enter and exit the fund at various intervals. They continuously raise capital, offering more flexibility for investors. There may be an initial ‘lock-up’ period that varies from fund to fund, depending on the underlying investments. Examples for lock-up periods are twelve months to three years. These funds tend to take investment capital in full on application, (referred to as ‘fully-drawn’). Care should be taken to read the fund terms as there may be early redemption penalties, and after the lock-up’ period there may be a limit to withdrawals. For example 5% of the fund per quarter may be a maximum, perhaps more or less, with the fund reserving the right to ‘gate’ the fund and slow or stop redemptions.
Closed-end funds
These funds raise a fixed amount of capital during their initial fundraising period and do not accept new investments afterward. Typical fund terms are between 8 to 15 years, with 10 years being most common. They may have specific commitment dates and might be open for commitments once per quarter. Each commitment date is called a ‘closing date’, with the initial date being the first close and the final date the final close. Once an investor makes a commitment, the closed-end fund can then call capital against those commitments in instalments – like buying on a payment plan - most often this is over a 2 to 4 year investment period. Capital distributions are made in later years of the fund with most capital returned before the fund matures. There may be optional extensions to maturity.
Private equity has the potential to offer attractive returns, typically ranging from 8% to 15% per annum, sometimes more, depending on the stage and type of investment. However, it’s important to note that these returns come with inherent risks, including:
There is a difference between how returns are calculated for fully-drawn funds and capital call funds. Open-end funds tend to be fully-drawn while closed-end funds are usually capital-call funds.
Closed-end funds
Return characteristics of a closed-end fund can exhibit a pattern of net asset value (NAV) and cumulative distributions called a J-Curve. Think of this as similar to buying a house or property fund that must incur some initial expenses such as stamp duty and fund set up costs before the property can be revalued at least a year later. For private equity funds this period of lower net asset value can persist for more than one year (up to three is not unusual) before returning to growth. After ten years, the fund tends to see its strongest growth in the second half of ownership as this is when revaluations and distributions accelerate.
Returns are calculated on a cash flow basis using an ‘internal rate of return’ or ‘IRR’ methodology. In summary IRR is the compound annual rate of return that equates the net present value of all the cashflows to zero.
This does not mean that the returns happen smoothly over time, in fact the returns are most often negative in early years and positive to very positive in later years. The IRR reflects an ‘averaged’ return of the experience of the invested cash that gets drawn over the first few years and returned with greater capital in the last few years.
A term called Total Value to Paid In (TVPI) reflects the ratio of ‘money out’ to ‘money in’. This is based on dollars valued and distributed out divided by each dollar invested, but it does not consider the ‘time value of money’ or imply a percentage investment return. TVPI can also be referred to as ‘money on invested capital’ or ‘MOIC’.
Open-end funds
An open-end, fully-drawn fund will have a return that is more like a compounded return over time. While it may also not be smooth year-to-year, it is more likely to be within a narrower range than a closed-end fund. Think of this as a stock investment in a steady company that does not vary much in return from year-to-year but grows over time. The return is most often quoted in a per annum percentage rate that reflects the compound growth of $1 invested from day one. This compound return can vary from the IRR quite substantially but still end up with a compounded dollar value at the end that is the same as the closed-end fund.
For private equity funds, distributions are most often as capital, and not income, so they will be taxed at the capital gains rate. Sometimes income could be distributed but this is more common in infrastructure funds rather than private equity funds. Distributions will not be regular or easy to predict, as they depend on transactions to sell investments which takes time to identify buyers and negotiate sale terms.
When making decisions around private equity investments, investors should consider the following selection criteria and that it is being assessed by their advisor’s research team:
Private equity offers exciting opportunities for investors seeking higher returns and portfolio diversification. However, understanding the terminology is crucial for making informed decisions.
We hope this article has helped to demystify some of the key terminology surrounding private equity investments however we recommend you seek professional financial advice before making any financial decisions.
All information on this website is general in nature and is not intended to be advice. It does not take into account your financial circumstances, goals and objectives. Before acting, you should consider its appropriateness having regard to your own circumstances.