PE 101

What is private equity?

Private equity is an investment class which pools large sums of money from institutional investors (sovereign wealth funds, pension funds, large family offices, university endowments, ultra HNIs etc.) and takes concentrated investment bets on private companies (i.e. unlisted corporates).

GP and LP

GPs (general partners) are fund managers who are responsible for investing in companies and generating returns. Key responsibilities include fund raising and investment management.

LPs (limited partners) are the investors who have contributed to the fund that is being managed by the GP.

Time horizon and returns

PE funds typically have a fund life of 10-12 years and investment cycle of 5-6 years. A fund will typically aim to deploy the fund in the first 4-5 years and then start exiting from year 6 onwards.

LPs typically expect to generate a minimum of 10% USD IRR and funds (in India) typically aim to generate between 20-25% USD IRR returns.

Committed capital

Unlike mutual funds, PE funds have a concept of committed capital, where capital is drawn from the LPs by doing capital calls when an investment opportunity arises. Similarly, capital is also returned as and when exits take place. This is done to avoid any negative carry (drag on the overall returns) given that PE is a high yield business and it will be difficult to find investment / reinvestment opportunities at such high returns for shorter time horizons to park funds.

What is MOIC and IRR

MOIC (multiple on invested capital) is the return generated in absolute terms whereas IRR is time weighted returns generated on an investment. IRR is the annualised rate of return over the investment horizon. For eg if you invested $100 and returned $200 after 5 years, your MOIC on the investment is 2x (that is you managed to double the initial investment of $100) and IRR is 15%. However, if you generated a 2x return in 10 years, the MOIC is still 2x but IRR is 7%

What is the 2/20 fee structure in PE?

LPs are typically charged 2% fixed fee on their committed capital and 20% of profits on returns generated over a certain threshold (typically 10% USD IRR). This is commonly referred to as the 2/20 structure. It is interesting to note that the 20% profit is generally with catchup – meaning if a fund generates 15% USD IRR which had a hurdle rate 10%, it will receive 20% of the profits (carried interest) on the entire 15% IRR and not the incremental 5% return over the 10% hurdle.