Private Equity 101: The Art of the Deal

A private equity investment is a type of alternative investment. Individuals own a portion of a company that is not publicly owned, quoted or traded on a stock exchange. Most private equity firms are open to accredited investors or those who are deemed high-net-worth. Since the basis of private equity investment is a direct investment into a firm—often to gain a significant level of influence over the firm’s operations—quite a large capital outlay is required, which is why larger funds with deep pockets dominate the industry. The minimum amount of capital required for investors can vary depending on the firm and fund. Some funds have a $250,000 minimum investment requirement, while others can require millions of dollars. The underlying motivation for such commitments is, of course, the pursuit of achieving a positive return on investment (ROI). Partners at private-equity firms raise funds and manage these monies to yield favorable returns for their shareholder clients, typically with an investment horizon between four and seven years.
Private EquityPublic Equity
Uses private information to make decisions
Investors as operators
Private concentrated ownership
Multi-year strategic planning
Ability to retain entrepreneurs and attract skilled managers through equity participation
Public information
Passive investors
Broad public ownership
Quarterly earnings focus
Traditional incentive structures (options, restricted stock grants)
Private equity can be split into different areas: leveraged buyout, venture capital, mezzanine, distressed debt, and real estate.
With the recent volatility experienced in the public stock and bond markets, investors are starting to look towards private equity as a really viable alternative investment instrument. Earlier this year, I discussed my 2020 allocation strategy. I highlighted that the largest expected change would be the increased allocation towards private deals (either equity or debt). Although the emergence of the Corona-virus has recently made me increase my funding towards the stock market, I have also been evaluating a couple of private equity deals within the commercial real estate space. In particular, the deals have been mostly hotel and apartment investments managed by different teams.
I typically spread my investments across different platforms, one of which is Nextseed. Nextseed is a fast-growing fintech company that empowers everyday investors to invest directly in local businesses, enabling private companies across the US to raise capital directly from their community. The team is made up of experts who vet every offering on their platform, giving people real opportunities to invest in businesses they believe in. Only the top 3% business applicants are approved with campaigns launched. Here is a referral link to Nextseed for those interested. There is a particular commercial real estate investment opportunity open to accredited investors that I have recently evaluated and provides a good understanding on how private equity deals are structured. Below are the key terms that investors usually come across when looking at private equity deals:
Nextseed offers investment opportunities in a varied amount of deals
You can invest in structured deals on Nextseed
1. Structure
The way it is typically structured is that we have a general partner “GP” and limited partners “LPs.” The general partner is the private equity firm and the investors are the limited partners. Limited partners generally consist of pension funds, institutional accounts and wealthy individuals. The general partner invests the fund’s committed capital in public and private companies, manages the portfolio of investments and seeks to exit the investments in the future for sizable returns. A general partner may manage one or a few funds that may have different investment restrictions such as geography, industry or typical size of each investment.
2. Fees
General partners generally charge both a management fee and a performance fee. While this varies by firm and its funds, typical management fees consist of 2% of assets under management and performance fees of 20% which are taken from exited investments. Performance fees are also called “carried interest” or “carry”. In some instances, there is a hurdle rate which is a % return (typically 8-10%) that LPs must receive before performance fees can be received by the general partner. Performance fees motivate the private equity firms to generate superior realized returns. These fees are intended to align the interests of the general partner and its LPs.

3. Fund Life
Private equity funds typically have long lives. The term of a fund begins following the first fund closing.

4. Investment Process
An investment can take between 4-6 weeks to identify and close. The investment process usually begins with the source lead. The source lead is phase in which the quality investments are being researched and found. The sources can range from personal networks, business owners, to investment banks. An indication of interest coupled with an iterative valuation (based on the ongoing negotiations of the target investors IRR) is then undertaken and a letter of intent is written. After all these, due diligence is conducted and a purchase agreement is put in place. Finally, capital is raised through equity and debt sources.
Waterfall Scenario
Here is a realistic scenario showing how all the key terms come into play in private equity distributions. It should be relatively easy to follow!

Distributions of Income and Capital:
All amounts allocated to the General Partner and the Limited Partners shall, after payment of or making appropriate provision (if any) for costs, liabilities, tax, expenses and working capital requirements of the Partnership, be distributed in the following order:-
(i) General Partner Management Fee: firstly to the General Partner in respect of the amounts payable to the General Partner in relation to any Management Fees which have not been paid;
(ii) Return of Limited Partner Capital Contributions: secondly to the Limited Partners (pro rata to their respective Capital Contributions) until they have received back their aggregate drawn down Commitments;
(iii) Preferred Return: thirdly to the Limited Partners (pro rata to their respective Capital Contributions) until aggregate distributions under this paragraph (c) are equal to the Preferred Return (8%);
(iv) Catch-up: fourthly 80% to the General Partner and 20% to the Limited Partners (pro rata to their respective Capital Contributions) until the General Partner has received amounts equal to 20% of the total amounts distributed to Limited Partners under paragraph (iii) above and to the Limited Partners and the General Partner under this paragraph (iv); and
(v) 80/20 split: thereafter 80% to the Limited Partners (pro rata to their respective Capital Contributions) and 20% to the General Partner.”
A few things to note are the carried interest structure strongly incentivizes the GP to beat the market. Unless the GP beats the hurdle rate, all it gets are the management fees and other costs and expenses that can be charged back to the fund. The carried interest structure also meets LP concerns by giving them a preferred return up to the cost of capital for that asset class. With that preferred, the LP will often be happy with an incentive structure that strongly encourages the GP to generate additional value.


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