Spelling Out Basics of Investment Categories
By KATE BERRY
Staff Reporter
When the stock market began to decline in March 2000, it highlighted one of the major weaknesses of private equity investments: Risks are difficult to evaluate and information is almost never disseminated to the public.
Though individual investors cannot invest directly in private equity funds, anyone with a pension fund has a portion of their retirement income allocated to little-known venture capital and buyout firms that have, in turn, invested in virtually unknown private start-ups or private mid-sized companies. Here are the basics.
Question: What’s the difference between private equity and venture capital?
Answer: Private equity is a general term for investing in private companies. Technically, private equity investments include both buyouts and venture capital and some private equity firms engage in both. But when people refer to private equity they’re mostly referring to buyouts often deals that leave existing management in place and use a significant amount of debt. Hence the terms management-led buyout and leveraged buyout.
Venture capital involves early-stage or “seed” investments for start-up companies. Usually several venture capital firms will take control of a new company with the intent of taking it public and making millions on their investment by selling shares to the public.
Private equity firms also invest in inefficient or poorly managed companies that they can help whip into shape and sell at a profit several years later.
Q: How large are private equity funds?
A: Size varies, but they are getting bigger. Generally, private equity funds range from about $100 million to $5 billion or so. Venture capital funds tend to be smaller, from several million dollars to several hundred million, although some are larger.
Q. Can anybody invest in these firms?
A: No. Investors in private equity firms include large pension funds, insurance companies, college endowments and high net-worth individuals. The California Public Employees Retirement System, known as Calpers, is the largest private equity investor in the United States with $20 billion in commitments, or roughly 8 percent of its total $165 billion portfolio.
The Los Angeles County Employees’ Retirement System, known as LACERS, also invests in private equity firms. Private equity and real estate are lumped into a category known as alternative investments, which are considered to be more risky and, hence, are supposed to throw off higher returns.
Q. How much action is there here?
A: Southern California has a significant number of private equity firms because of its size, location and large number of mid-sized privately held companies. Many VC firms, by contrast, are located in Silicon Valley because of their proximity to technology start-ups.
Large buyout firms in Southern California include Leonard Green & Partners and Freeman Spogli & Co. These and several other prominent shops are run by veterans of long-defunct Drexel Burnham Lambert, where Michael Milken pioneered the use of high-yield junk bonds in the 1980s.
Q. How do venture capitalists and buyout firms make their money?
A: The manager of a private equity partnership is called the general partner while the investors who provide most of the money are called limited partners. General partners receive a management fee and a percentage of the profits, or “carried interest.” Typically, management fees run between 1.5 percent and 2.5 percent per year of the total capital committed.
Carried interest is a profit incentive meant to align the interests of the general partner with those of the limited partners. Most firms take 20 percent of gross profits, though some firms take as much as 30 percent.
Many funds also have a feature that adds an 8 percent compounded rate of return per year if the manager exceeds the fund’s specified “preferred return.” If they don’t hit that benchmark, the general partner is not entitled to the carried interest. Because the firms are private, the fees are rarely disclosed to the public.
Q. How does a private equity firm find a large investor?
A. A firm typically hires a placement agent or investment banker to put together an offering memorandum and pitch book of material showing past rates of return.
Q: How do they find the investments?
A: Companies are targeted through a variety of methods, from contacts with investment bankers to cold calling.
Buyout firms typically have a set period of time to invest the money that has been committed, usually about four to five years. In the past few years, billions of dollars in private equity has been waiting on the sidelines to be deployed.
