Box 1.1
RAISING A SUCCESSOR FUND
Established PE firms will raise successor funds every three to four years and ask existing LPs to “re-up” – or reinvest – in their new vehicle. PE firms will typically begin raising a successor fund as soon as permitted by the LPA, usually once 75 % of the current fund’s capital is invested or has been reserved for fees and future deals.
PE firms see their business as a going concern, meaning they continuously work on a deal pipeline of potential investee companies, make investments and divestments. To efficiently capitalize on opportunities in the market, it is crucial for PE firms to have access to capital, ready to be drawn down and deployed, at all times. This also allows a firm to maintain stable operations, employ an investment team and maximize the efficiency of its resources.
Exhibit 1.5 shows the lifecycle of a successful PE firm with a family of four funds.
Exhibit 1.5 Lifecycle of a Successful PE Firm
THE LP PERSPECTIVE
COMMITTING CAPITAL AND EARNING RETURNS
Investors have traditionally allocated capital to PE due to its historical outperformance of more traditional asset classes such as public equity and fixed income.17 However, this outperformance comes with higher (or rather different) risks first and foremost due to the illiquid nature of PE investments. Given its lack of liquidity and the long investment horizon of a PE fund, hitting a target allocation to PE is a far more challenging task than maintaining a stable allocation to any of the liquid asset classes.18 In addition, PE funds’ multiyear lock-up and 10-day notice period for capital calls introduce complex liquidity management questions.
Effectively managing portfolio cash flows is among the key challenges faced by investors in the PE asset class. LPs starting a PE investment program from scratch must prepare for years of negative cumulative cash flows before a positive net return will eventually be generated by their PE portfolios. Seasoned investors with a well-diversified exposure to PE, on the other hand, will often have commitments to well over 100 funds and a complex set of cash flows to manage. A PE fund’s “J-curve” provides a way to visualize the expected cash flow characteristics of an LP’s stake in an individual PE fund and the challenges related to managing a PE portfolio.
THE J-CURVE
A PE J-curve represents an LP’s cumulative net cash flow position – the total capital invested along with fees paid to the PE firm minus the capital returned to the LP by the GP – in a single fund over time. Exhibit 1.6 illustrates the characteristic cash flow for an LP (with a US$10 million commitment to a $100 million fund) over the fund’s 10-year life. For simplicity’s sake we assume both consistent drawdowns from the GP and exits split evenly across the years. It should be noted that capital calls and distributions are difficult to forecast with any degree of accuracy, requiring LPs to develop a flexible approach to cash management.19
Exhibit 1.6 PE Fund Cash Flow J-curve
Early in the investment period, the J-curve has a steep negative slope, as a fund’s initial investments and management fees (paid on committed capital) result in large cash outflows for its LPs. As the fund begins to exit its portfolio company holdings, distributions of capital slow the J-curve’s descent; some funds may in fact show a positive slope before the end of the investment period. While the low point of a J-curve is theoretically defined as the fund’s total committed capital, J-curves rarely dip below 80 % of committed capital due to the time required to deploy capital and early divestment activity. In fact, many funds do not even reach a net drawdown of more than 50 %.
Following the start of the divestment period, the J-curve turns upward as exit activity picks up and invested capital plus a share of profits are returned to LPs. Capital called for follow-on investments and management fees continue to generate small LP outflows during the divestment period. As soon as the J-curve crosses the x-axis, the fund has reached breakeven; the final point on the J-curve represents an LP’s total net profit generated by the fund.
While LPs will attempt to optimize their portfolio allocation, modeling cash flows as well as net asset values remains challenging, given the blind pool nature of the funds and the overall scarcity of data in PE. The secondaries market nowadays offers a realistic avenue to add liquidity, shorten the J-curve and manage a PE portfolio proactively.
THE FEE STRUCTURE AND ECONOMICS OF PE
OR WHO EARNS WHAT?
The typical fee structure of a PE fund is designed to align the economic interest of the PE firm and its fund investors. The fee structure in PE is commonly referred to as “2 and 20” and defines how a fund’s investment manager and GP – and in turn its PE professionals – are compensated: the “2 %” refers to the management fee paid by the LPs per annum to a fund’s investment manager while the “20” represents the percentage of net fund profits – referred to as carried interest or “carry” – paid to its GP. The clear majority of profits, 80 %, generated by a fund is distributed pro rata to a fund’s LPs. As long as carried interest remains the main economic incentive for PE professionals, their focus will continue to be on maximizing returns, which in turn benefits the LPs. Exhibit 1.7 visualizes the flow of fees and share of net profits to the entities involved in a PE fund.
Exhibit 1.7 PE Fees and Carried Interest
Returns in PE are typically measured in both internal rate of return and multiples of money invested.20 Given a fund’s cost structure, its net return – that is, the return on capital generated by the fund net of management fees and carried interest – is the relevant metric for its investors and LPs will ultimately define success on that basis at the end of the fund’s life.
We take a detailed look at fees and carried interest below.
MANAGEMENT FEES: A PE fund’s investment manager charges the fund – and ultimately its LPs – an annual management fee to cover all day-to-day expenses of the fund, including salaries, office rent and costs related to deal sourcing and monitoring portfolio investments. In the early days of PE, the management fee charged was an almost consistent 2 % per annum, yet currently it ranges from 1.3 to 2.5 % depending on the size and strategy of a fund and the bargaining power of the PE firm during fundraising. For example, it is accepted that smaller, first-time funds will charge higher fees to cover their fixed