Nowadays, people can easily buy or sell stocks or bonds of listed companies as part of their personal investment portfolio. To be listed on public markets, companies must meet strict requirements and disclose a significant amount of information. However, not all companies can meet these requirements or wish to become public. These companies rely on private markets for their corporate financing, attracting sophisticated investors like institutions or wealthy individuals, as opposed to simple public investors like you and me. Just like public markets, in private markets, people can invest in stocks (stocks), credit (bonds) or assets (real estate, infrastructure and equipment).
The life cycle of a private equity fund begins with a “money pool”, called a fund. Fund managers approach potential investors who then agree to commit capital to the fund for future investment. At this point, investors’ money is not sent to the fund account. This only happens when the fund manager calls up capital when he invests in a holding company. In years 6 to 10, fund managers begin to leave the portfolio companies by selling or transferring their property and returning capital (cash or stocks) to investors. In the context of private equity, fund managers are called general partners, or GPs, and are responsible for the day-to-day operations and management of the funds. Investors in the fund are called limited partners, or LPs, and they contribute capital and delegate management rights to GPs.
For private market transactions, there are no predefined rules, so GPs must spend more time structuring and negotiating transactions. Once the agreement is approved, GPs will intervene in the companies in which they invest, called holding companies, and will look for opportunities to add value to them, thereby increasing the value of their investment. GPs normally have in-depth knowledge of their area of investment. Their expertise can be useful for improving the operational efficiency of portfolio companies and optimizing capital structures through financial engineering. Sometimes they can even become members of the board of directors and lead the strategic direction of the company.
Depending on the stages of the companies in the portfolio, the private equity fund can be classified into four categories from the emergence of a company to its disappearance: venture capital, growth capital, buyout funds and special situation funds.
In deciding which fund to invest in, LPs will carefully assess the track record of a fund manager by analyzing the performance and return on investment of the fund. Regardless of performance, GPs charge LPs a fixed amount (known as a management fee) each year for daily operations; for example, if the value of the investment exceeds the predefined minimum expected return (a figure known as an obstacle), staff receive an additional reward known as interest earned in addition to their wages. This fee structure aligns the interests of GPs and LPs, so that both partners are motivated to improve the performance of the fund. Sourcing transactions and creating value are the two other parameters that investors will take into account when choosing a fund. A good manager must have access to bilateral “off the market” agreements and have internal experts to manage the companies acquired.
Within the private equity universe, in addition to the LPs and GPs who are responsible for capital investment, fund administrators and fund custodians also play an important role in the process. Fund administrators prepare financial statements, pay fund expenses, monitor regulatory compliance and perform other administrative duties. Fund custodians are financial institutions that hold and protect the assets held by the fund. To avoid any conflict of interest, these two roles are independent of the GP and LP.