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Subject 3. Private equity fund structures and valuation PDF Download
Where does the money come from? Most of the money comes from institutional investors such as pension funds, endowments and insurance companies, although many high net-worth individuals also invest directly or through funds of funds intermediaries.

What about the funds themselves? Most funds are structured as limited partnerships. They are essentially tax-efficient investment vehicles which have a limited duration, almost always with a ten-year life. Investors commit a certain amount of money to a fund; the fund then asks the investors to send the money only as they find investment opportunities. These calls for capital take place over the first few years of the ten-year life of the fund.

Fees

Annual management fees usually at 1.5-2.5% of committed capital, paid annually to the GPs.

"Carried interest" usually equal to 20% of profits.

  • Profits are worked out on the basis of the entire fund; loses are netted against profits.
  • There is often a hurdle to jump, such as 8% IRR. Note this is a hurdle - once it is jumped, then GP gets 20% of total return (e.g., if IRR = 7% GP gets zero; if IRR = 10%, GP gets 2%).
  • Corporate governance terms to protect LPs.

Risks and Costs

By their nature, investments in privately equity funds tend to be riskier than investments in publicly traded companies. The risk factors include illiquidity of investments, unquoted investments, competition for attractive investment opportunities, agency risks, loss of capital, etc.

Costs are also higher than investments in public firms. They include transaction fees, set up costs, admin fees, placement fees, etc.

Due Diligence Investigations

Due diligence is a process designed to get a 360 degree view of the business. Since liquidity in private equity is very limited and performance range between funds is extremely large, a thorough due diligence on the fund must be conducted before any investment is made.

Valuation and Performance

Valuation of private equity investments is subject to significant judgment, as there is no market for securities issued by private equity companies. At what value should investments in portfolio companies be reported prior to the private equity fund exiting the investment and returning the proceeds to the LPs? How to value undrawn commitments? These questions are usually hard to answer.

Some characteristics of private equity funds performance:

  • Managers of private funds can operate outside the public arena. Evidence on returns is likely to suffer from selection bias because funds are more likely to reveal their returns if these returns have been impressive.
  • Early-stage returns have been very disappointing.
  • Funds differ significantly in their performance.
  • Superior performance by particular private equity firms is persistent over time as they raise new funds. Hence, when investing in private equity, manager selection is everything.

Investors normally focus on two metrics:

  • IRR.
  • Realization ratios:

    • PIC: paid in capital.
    • DPI: Distribution to Paid-In ratio. The DPI measures the ratio of distributions to the limited partners compared to the amount of capital contributed by the limited partners.
    • RVPI: Residual Value to Paid-In ratio. The RVPI measures the net asset value of the funds (unrealized gains), compared to the amount of capital contributed by the limited partners.
    • TVPI: Total Value to Paid-In ratio. The TVPI is simply the DPI and RVPI added together.

    A drawback of these ratios is that they do not take into account the time value of money, but are simply based on actual capital figures. For this reason, it is recommended that they be used in conjunction with the IRRs.

Learning Outcome Statements

explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis of private equity fund returns;

explain risks and costs of investing in private equity;

interpret and compare financial performance of private equity funds from the perspective of an investor;

calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund.

CFA® 2023 Level II Curriculum, Volume 5, Module 38

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