1. Introduction to Private Equity

What is Private Equity (PE)?

• Equity capital invested in companies that are not listed on public exchanges

• Includes direct investments into private firms and buyouts of public firms that are taken private

• Usually organised in closed-end funds managed by a PE firm (General Partner) on behalf of investors (Limited Partners)

Main PE strategies by company situation

• Venture Capital: minority stakes in early-stage, high-growth firms, typically negative cash flows

• Growth Equity: minority or majority stakes in profitable, growing firms needing capital to expand

• Buyout: acquisition of control using significant leverage, cash-generative targets

• Special Situations / Distressed: investments in stressed or restructuring companies, often with complex capital structures

Typical investors (LPs) in PE funds

• Pension funds and insurance companies

• Sovereign wealth funds and endowments

• Family offices and high-net-worth individuals

• Fund-of-funds investing only into other PE funds

Difference GP vs LP

• General Partner (GP): manages fund, sources and executes deals, sits on boards

• Limited Partners (LPs): commit capital, have limited liability, are economically exposed but do not manage day-to-day

• GP usually commits a small share of total capital to ensure alignment

How does a PE fund earn money at GP level?

• Management fee: usually ~1.5–2% per year on commitments during investment period, later on invested or remaining capital

• Carried interest: ~20% of total profits above LPs’ preferred return (hurdle)

• Transaction and monitoring fees: paid by portfolio companies, often partially rebated to LPs

What is the management fee and what is it for?

• Annual fee charged by GP to LPs on commitments or invested capital

• Typically 1.5–2% p.a. during investment period

• Covers salaries, deal sourcing, rent, basic overhead and running the platform

What is carried interest (“carry”)?

• Performance fee that rewards GP once LPs have first received their capital plus preferred return

• Typically structured so that investors keep 80% and GP receives 20% of total profits above hurdle

• Creates strong performance incentive but only pays out after profitable exits (“back-ended”)

What is a hurdle / preferred return?

• Minimum annualised return LPs must receive before carry is paid to GP

• Often set around 8% IRR net to LPs

• Protects LPs from paying performance fees on mediocre outcomes

What is a “fund commitment”?

• Maximum capital an LP legally agrees to provide to the fund over its life

• Drawn over time via capital calls rather than paid up-front

• Unused commitment is often called “dry powder”

What is a capital call?

• Formal request by GP for LPs to transfer part of committed capital

• Used to fund new investments, pay fees and cover fund expenses

• Typically gives LPs a short notice period to wire the cash

What is the life cycle of a typical PE fund?

• Fundraising: 1–2 years of raising commitments and building deal pipeline

• Investment period: roughly first 5 years, new deals, follow-ons, some early exits

• Harvesting / divestment period: exits, portfolio optimisation, new fundraising

• Total fund life: usually 10–12 years (extension options possible)

Why do LPs avoid vintage concentration?

• Spreading commitments across different starting years diversifies macro cycles

• Reduces risk of committing all capital just before a downturn

• Smooths the future distribution pattern (less lumpy cash-flows)

What is Net Asset Value (NAV) of a PE fund?

• Bottom-up valuation of all remaining portfolio companies plus other net assets

• Uses DCF and comparables, updated periodically and often audited

• Represents residual value for LPs before fees and carry on unrealised gains

What is IRR in PE fund context?

• Discount rate that sets NPV of all cash flows (capital calls = negatives, distributions = positives) equal to zero

• Handles irregular timing of cash flows, important given drawdown and exit profile

• Standard performance metric reported net of management fees and carry

Money Multiple (MM) definition and intuition

• MM = Total capital received / Total capital invested

• Ignores timing but shows total value created per euro invested

• Example: invest 10, receive 30 ⇒ MM = 3.0x

TVPI and DPI: definitions

• TVPI (Total Value to Paid-In): (Distributions + NAV) / Capital called ⇒ total value multiple

• DPI (Distributed to Paid-In): Cumulative distributions / Capital called ⇒ cash multiple realised

• DPI > 1 means investor has at least broken even in cash terms

Why use both IRR and multiples to assess PE performance?

• IRR captures timing (early vs late exits)

• Multiples capture absolute value creation regardless of timing

• Using both avoids praising a fund with high IRR from quick small deals or under-rating a fund with large but slow wins

What is a primary PE investment from LP point of view?

• LP commits capital directly to a new PE fund at launch

• Capital is drawn gradually as GP finds new deals

• Exposure starts as a “blind pool” (companies not yet known)

What is a secondary PE investment?

• Purchase or sale of existing fund interests or their unfunded commitments

• Buyer gains exposure to a more mature portfolio (less blind-pool risk)

• Often shorter holding period and faster distributions than primaries

Advantages of secondary investments for LPs

• Reduced blind-pool risk, as underlying portfolio is partially known

• Avoids early-year write-offs of original fund

• Shorter duration and often quicker J-curve reversal

What is a co-investment?

• Direct investment by LP alongside GP into a specific deal

• LP holds both fund units and direct equity in portfolio company

• Often comes with reduced or zero management fee and carry on the co-investment

Basics of a leveraged buyout (LBO)

• Acquisition of an operating company using significant debt funding

• Assets and cash flows of the target secure and service the debt

• PE aims to exit in ~3–7 years with high IRR and MM by improving operations and paying down debt

Typical risk-return ordering across PE strategies

• Highest risk / return: Venture Capital

• Mid: Growth equity, Leveraged Buyouts

• Lower: Mezzanine, some distressed and infrastructure strategies

• Exam logic: VC > LBO > Mezzanine in risk

Typical target returns and holding period for buyout funds

• Target IRR: >20–25% for successful deals

• Target Money Multiple: >2.5x on equity invested

• Target holding period: around 3–7 years, depending on value-creation plan

Characteristics of an attractive LBO target

• Strong, stable and predictable free cash flow

• Limited capex needs and favourable working-capital dynamics

• Defensible competitive position and clear growth prospects

• Existing low leverage so balance sheet can support new debt

Typical PE exit routes

• Trade sale: sale to a strategic (industrial) buyer, often with synergies

• Secondary sale: sale to another PE fund

• IPO: listing shares and selling fully or gradually on public markets

• Recapitalisation: leveraging the company and taking cash out as dividend

What is the most an LP in a PE fund can lose?

A) Half their contributions

B) The sum of their capital contributions only

C) Contributions plus any fund liabilities

D) Nothing

• Correct: B) The sum of their capital contributions only

• LP liability is contractually limited to committed capital

• Fund-level borrowing is usually non-recourse to LPs

PE performance measures include which of the following?

A) IRR, Money Multiple, NPV

B) IRR and Money Multiple

C) Money Multiple and NPV only

D) Only IRR

• Correct: B) IRR and Money Multiple

• NPV is not normally used as headline fund metric

• Exams like to mark A) as wrong because of “NPV”

Equity out / Equity in measures what?

• It is the Money Multiple on equity

• Numerator: equity proceeds at exit

• Denominator: equity invested at entry

Why does using debt increase potential equity returns (and risk)?

• Less equity is needed to control the same enterprise value

• Any EV upside is divided over a smaller equity base ⇒ higher % return

• But fixed interest and principal make equity more sensitive to downturns