Private Equity

Most Common Terms Within Private Equity

Suppose you’re an Operator with deep functional know-how in a specific industry. In that case, you already know every piece of slang or jargon necessary to sound like you aren’t speaking English to the everyday person. But, if you’re looking to make the switch into the fast-paced, hyper-growth-focused realm of private equity-backed companies, there are a few more pieces of lingo to add to your arsenal to stop being an outsider.

A brief overview of private equity in its current state:

  • The holding period for an acquired portfolio company is typically 3-5 years
  • On average, firms will target to 3x their money within 5 years, which is a 25% IRR
  • PE investments are more illiquid than public markets, and exiting early is only done if necessary
  • Only accredited investors can invest in private equity funds
  • Some funds have $5-25million investment commitment amounts from outside capital, while others have decreased their minimum investment amount to $25-100k
General Partner

The simplest way to think of a general partnership is the entity comprised of the individuals that manage the private equity firm. They are responsible for finding strong investments, determining the direction of growth to take said investments, and thus typically earn a management fee of 2% of the assets they manage, as well as a share of fund profits, which usually fall around 20%. In the last 10 years, we have seen investors raise the management fee and carried interest percentages depending on whether or not the fund has been oversubscribed / has a strong track record, if they are a first-time manager, or performed poorly in the past, they will lower these percentages to entice investors.

Limited Partner

Limited Partners are the investors who pay and invest money into the general partner or private equity firm with hopes to grow their money in an alternative fashion to public markets. They have full protection from any legal action taken against the general partner or its portfolio company, as well as protection from any losses beyond their initial investment into a private equity fund.

Limited partners are often comprised of pension funds, school endowments, insurance companies, and high-net-worth individuals.

Carried Interest

If you’ve ever wondered how private equity firms make the majority of their money, carried interest is your answer. The industry standard amount of 20% of the profits generated by the fund, which, if you’ve been paying attention, is at least a three-year hold time, which qualifies these profits to be taxed as long-term capital gains, translating to even more dollars in the GP and LPs pockets.

Preferred Return

You could spend days learning about all of the different structurings of returns and compensations - we aren’t going to get too granular on those here, but rather focusing on the key ones necessary to understand the general construct of a private equity deal and corresponding fund. Preferred return (oftentimes called the hurdle rate), is the minimum rate of return (annual) that the limited partners are required to earn before the general partners can earn carried interest from the deals they have exited. The industry standard hurdle rate is 8%, but we have seen some high-growth software investors boast a 10% hurdle rate with a 30% carried interest, signifying that they are good, they know it, and you’ll pay extra for the pleasure of investing with them.

Internal Rate of Return (IRR)

IRR is one of the primary benchmarks you will see used across all of venture capital and private equity. Whether it is the profitability and success of a fund or that of an investment within a fund, IRR is how to see its success (one must be aware, that due to its popularity, there are bound to be some contrarians who find other methods more encompassing - in our opinion, IRR with MOIC as a sidekick are the best duo).

We won’t get into the formula to calculate it, but just know that it is the compound annual return rate, and assumes all cash flows are positive and will be subsequently reinvested for the life of the investment.

Multiple on Invested Capital (MOIC)

This is an easy one - MOIC is purely the total return over the life of an investment, with the time value of money not taken into consideration. The metric is primarily used within the private markets, so you won’t find it on any stock exchange or ETF write-ups.

Residual Value

Residual value is the total remaining value within the fund’s portfolio investments. The reason it matters is to compare, for example, a fund has two deals that go bust but you want to see whether the rest of the profitable deals pick up the slack, and determine whether the LPs still made a return from their investment. The residual value is compared against the asset’s purchase price, and depending on if there is a positive or negative number, shows the profit or loss (unrealized).

Cumulative Distribution

Investing in many private equity funds, LPs want to know the track record of the investment team before handing over millions of dollars. They will look at the returns, specific deals, any competitive advantages they possess, and any cumulative distributions (the returns paid out to previous LPs) to determine whether the investment team is worth their salt.

Committed Capital

When LPs commit to a fund, they don't fork over all of the money right away, they will have 10 million of committed capital to the fund, and as the fund identifies investments, they will issue capital calls to the LPs, meaning they will request some of the committed capital so they can complete their investments.

Assets Under Management

You will often see “$1 Billion AUM” on a private equity firm’s website. This simply means they are managing one billion dollars worth of companies and company assets (measured in enterprise value, or, the total value of each portfolio company). There is no good or bad amount in regards to AUM, some investors like to stay lean and manage a small fund every ten years, and some teams will raise 10 funds at any single time (with different investment focuses), all above a billion dollars each.

In Summary

Private Equity has no plans on stopping its major bull run with record amounts of dry powder (capital ready to be deployed). As it grows in popularity (partially thanks to politicians campaigning against it), terms like the ones above will become more mainstream, and thus, so will hiring roles for private equity-backed companies. When you’re in a situation needing to show off some of your surface-level industry knowledge, save this article and give us a call.

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