From the perspective of a Private Equity backed management team, it’s not always clear what motivates investors, and how the funding process works. In order to shine some light into the darkness, we’ll take a closer look at where the funding comes from, and explore what the funding lifecycle looks like.
In this article you’ll discover:
- Where the money comes from
- How investors make money
- How the exit process is managed
Let’s start by looking at where the money comes from – who your investors are, what drives them, and what that means for you and your business.
Where does the money come from?
There are two types of investors, neither of whom are interested in running the businesses they have invested in; their focus lies in maximising return on investment:
- General Partners (GPs) – are the private equity houses. Typically they have backgrounds in investment banking, accounting and corporate finance, and management consulting. To ensure alignment of interest with the LPs and to ensure the GP has ‘skin in the game’ (see below), GPs are usually required to make an investment of their own money into the fund. On average this is 2% of the entire fund but it does vary.
- Limited Partners (LPs) – institutional investors such as pension funds, insurance companies, sovereign wealth funds and endowment funds typically provide the vast majority of the fund. Their money doesn’t come in one big payment; instead they make a commitment at the outset of the fund and their capital is ‘drawndown’ by the private equity firm when they invest in a new business. The initial securing of LP commitment or ‘fundraising’ process can take up to a year.
How do investors make money?
Reflecting the unlisted, illiquid and often leveraged investment strategies, Limited Partners usually look for a 2 – 2.5x return on their total investment. Private Equity funds typically have a ten year lifetime, by which time the LPs will wish to have received all their initial capital and returns back. Success is essential to GPs, they’ll need to show they can deliver returns early in the fund lifecycle to ensure they have a track record to support the next fund raise.
There are three routes through which investors make money:
- Fees. Typically around 2% of the capital committed, these management fees pay investors’ running costs. However, they are paid back out of the profit realised at the end of the fund.
- Co-invest and Carry. The initial stake that General Partners are required to put in is known as the ‘co-invest’. As their portfolio businesses grow and are sold for an increased multiple, so the money they initially invested grows too.
- Carried Interest. Once they have delivered a preferred return (the hurdle) over and above the return of the drawn capital + the 2% annual fees, GPs are usually entitled to 20% of profits. The hurdle rate is usually set at a compound IRR of 8% on drawn capital.
Over and out: delivering an exit process
Funds typically have a ten year initial period, usually with a five year investment period and a further five year period for realisations, with LPs receiving financial performance every quarter.
GPs watch the market closely, monitoring sector EBITDA (earnings before interest, taxes, depreciation, and amortization) and the performance of other PE funds. If they see increasing activity and expectation in the wider market, they may decide to drive for an earlier exit – after all, it’s about maximising their return in ideally the shortest time possible so they can build their case for future fundraising.
Most PE houses take a bottom-up approach to managing exit sequencing, considering three key triggers:
- Market conditions – sector activity and / or deal frequency, multiples being paid, regulatory changes that may impact performance and so on.
- Business performance, measured against the investment thesis (assurances made to LPs at the start of the process), annual growth and the competitive set.
- Fund dynamics – investor fees are chargeable when 75% of the fund is deployed, at which point investment in their next fund can begin. Demonstrating success within the first five years is therefore crucial.
At the outset of a new investment a business and investment case is prepared. If returns are on track, the GP must weigh up whether to bank the money or hold out for further growth, and potentially a much bigger cheque in a couple of years. Judging the right time to exit the investment is crucial to returns.
Owning the investors relationship
Ultimately, as a PE-backed executive, your own success is intrinsically linked to your understanding of the PE model and your relationship with investors. It pays to be clear about your investor’s expectations and ensure you take ownership of driving the business’s Value Creation Plan.
With clarity around the PE funding process, and insight into what motivates your investors, you can better focus your efforts on exceeding their targets – delivering value and fuelling growth for the business that rewards all parties.