A THOROUGH UNDERSTANDING OF PRIVATE EQUITY

RETOUR SOMMAIRE

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - 2010

INDUSTRY OVERVIEW

called drawdown or capital call ) depends on the investment opportunities a private equity vehicle has identified and deems suitable. Once the commitment period is over, the fund’s manager will monitor and manage invest- ments to maximise value and realise returns over the life of the fund. Follow-up investments may require further draw downs of capital during this phase, but investments in new portfo- lio companies are usually prohibited. Figure 3 illustrates the investors’ cash flows during the investment period and the harvest period (the period when investors receive distributions), the returns , as well as the J-curve effect.

1.1

Figure 3: Investor’s cash flows and returns generated by private equity investments

Capital commitments are made at the fund's closing

Capital is drawn down as needed during the investment period (years 1-6)

Distributions to investors occur as investment exits are realised (years 3-10) and usually commence before the entire commitment has been drawn

Harvest period

Investment period

Investors'cash flows

Performance

Investment returns Distributions Capital calls

Year 1 Year 2 Year 3

Year 4 Year 5

Year 6 Year 7 Year 8 Year 9 Year 10

Copyright CACEIS, 2009

Private equity funds tend to deliver low or negative returns in early years and investment gains in the outlying years as the portfolios of companies mature and increase in value. The effect of this timing on the fund’s interim returns is known as the J-curve effect since a graph of returns versus time would then resemble the letter J, as illustrated above. In the initial years, investment returns are negative due to management fees, which are drawn from committed capital, and under-performing investments that are identified early and written down. It can take several years for the portfolio valuations to reflect the efforts of the GPs. Over time, progress is made by investee companies and justifies a value for the business that is higher than its original cost, resulting in unrealised gains. In the final years of the fund, the higher valuations of the businesses are confirmed by the partial or complete sale of investee companies, resulting in cash flows to the partners (GP and LPs). However, not all funds will be profitable given the inherent risk of investing in private equity. M anagement fee Throughout the life of the fund the manager of the private equity fund typically receives an annual fee called the management fee , as compensation for the investment management services rendered and irrespective of the distribution to be made to the shareholders.

A thorough understanding of PE | page 15