What is private equity?

Technically, it's any investment in a non-public company. In practice, many firms break down their private equity funds into venture capital (start-up and very young companies) and private equity (everything else). Some common activities for private equity funds: mezzanine investing (loans or equity investments in established companies), buyouts, vulture investing (bankrupt or restructuring companies), industry roll-ups and going-private transactions.

As private equity has grown, there has been some overlap with the activities of hedge funds, which generally will invest in securities (equities, debt, commodity futures, options and other derivative instruments). Private equity firms are also buying large stakes in public companies without taking them private. An example is Ron Burkle's Yucaipa Cos.' near-40 percent stake in Pathmark Stores Inc. In these deals, the public companies sometimes issue discounted shares to the private buyer.

How is private equity regulated?
Private fund managers are not subject to regulation by the Securities and Exchange Commission, the way that mutual fund managers are. The growth of private equity funds and hedge funds, and their impact on public markets, has led to calls for additional regulation. The biggest concerns are in the areas of PIPEs (private investment in public companies) and in fund-of-funds, where a fund manager will spread investors' capital through a number of private equity or venture capital funds. Many other funds invested and lost money in Bayou Management, the Stamford, Conn. hedge fund; the founders pleaded guilty to fraud. The SEC is conducting a probe of the PIPE industry, and many private fund managers, recognizing the concern, have registered with the SEC. Other funds are run by investment firms already registered.

How do I start a private equity fund?
The first step is to develop a business plan that outlines the goals, investment strategies and operating procedures of the fund. This should include a basic term sheet that discusses the fee structure, liquidity and valuation issues. Then hire professionals a law firm, accountants and such and get a management team in place.

How is it set up?
Funds can be structured as partnerships, trusts, corporations or limited liability companies. Tax issues and strategy of the fund may play a role in choosing a fund's structure. Many take the form of limited partnerships, with the fund manager as a general partner and investors as limited partners. Investors commit capital but don't actually provide it until the fund manager "calls" for it. The funds usually have a preferred or "hurdle" rate of return of 8 percent to 12 percent. The general partner usually keeps 20 percent of the profits from the fund, plus management fees of 1.5 percent to 2 percent of committed capital.

How does a fund raise money?
Funds look for qualified or accredited investors typically with a minimum annual income of $200,000 or net worth of $1 million. Many funds raise money from institutions such as pension funds, endowments and insurance companies. Increasingly, private funds are raising capital from fund-of-funds. To attract capital, the principals of the fund must have an established track record and an appealing strategy. This may include hiring an investment bank and making road show presentations to potential investors from one city to the next.

How does a fund select its investments?
A fund's strategy sets the parameters for what type of investment a firm will select. Funds will evaluate each potential investment on a case-by-case basis. Many private equity groups search out potential investments essentially cold-calling companies that might fit their scheme. This is especially true when the buyout fund is looking for acquisitions that fit a specific strategy, such as an industry roll-up. Other times the companies will pursue investors. There may be a management team seeking to take a division of a larger company private, or a growing company may be looking for a partner to finance its growth and share some of the risk. When a fund is considering investing in a company, it will conduct due diligence hiring a professional to go over the target company's books, looking at its assets and liabilities, pension obligations and its market position. Many potential deals fall apart at this stage; sometimes a firm will examine dozens of target acquisitions before finding one suitable for an investment.

How do funds cash in?
Normally a fund will have a target length it likes to hold on to its assets typically two to five years. During that time, the private equity group will try to reposition the company, alter its balance sheet or combine it with other holdings to put together a more attractive company for sale than the company (or companies) that it purchased. The resulting company can be sold to a corporate buyer or another private equity fund, to its management team, or offered to the public. Sometimes the private equity sponsor will maintain a partial holding after the sale.

For reprint and licensing requests for this article, CLICK HERE.