Investor Education

PE Fund Investors

PE Fund investors are typically large institutional investors such as sovereign wealth funds, state pension plans, university endowments, pooled retirement funds, insurance companies, and wealthy individuals.

PE Returns

A key industry metric for measuring a PE Fund's performance is its net internal rate of return ("IRR"); which factors in the irregular cash flows of PE investing. Historically, Buyout and Growth Equity strategies have produced the strongest performance as measured by the median net IRRs since inception of funds. Fig. 6 includes PE Funds with vintages 1990 to 2017.

Fig 6: Median Net IRR Returns by Strategy

Key Fund Terms

PE Funds are generally structured as limited partnerships, and are governed by a legal document known as a limited partnership agreement, or "LPA".

The key terms usually found in LPAs are shown below:

• Term
  Usually 10-11 years, which can often be extended by a further 2-3 years
  
  
• Capital Commitment
  Agreed amount that a LP is obliged under the LPA to contribute
  
  
• Commitment Period
  Period over which PE Fund commits to make new investments.
  Usually concludes on the 5th or 6th anniversary of the fund's inception.
  Typically, a PE Fund would aim to have called around 80-90% of its capital by the end of the Commitment Period.
  
  
• Distribution Waterfall
  Allocation and distribution of investment proceeds between LPs and GPs.
  May be applied on an individual investment basis ("American" waterfall) or on a pooled investment basis ("European" waterfall).
  
  
• Management Fees
  Fees for the GPs services.
  Usually range from between 1.3% to 2.5% of the aggregate committed capital of the PE Fund.
  
  
• Carried Interest
  Share of any PE Fund's profits that the GP receives, subject to certain performance hurdles.
  Usually 20% after investment cost has been recouped plus a "preferred return" of usually 8% net IRR to the LPs.

Fund Valuation

As opposed to public stocks, which are priced daily in the markets, a PE Fund and its underlying portfolio investments are generally valued on a quarterly basis by the GP. The GP typically determines the fund's NAV in accordance with internationally recognised accounting standards such as US GAAP and IFRS.

The Secondary Market

PE is considered to be an illiquid asset class. It does not have an established public trading market in which investors can sell their interests in the PE Funds, otherwise known as "LP interests". However, as a result of a maturing PE industry, there is better liquidity for secondary LP interests.

LPs might choose to sell their LP interests in the secondary market for many reasons. This includes monetisation of unrealised value, reduction of unfunded obligations, and general portfolio management/restructuring. Sales of LP interests in the secondary market can be conducted through broad auctions or negotiated transactions. The majority of LP interests are sold to dedicated asset managers known as secondary fund of funds which raise investment vehicles for the purpose of acquiring LP interests in the secondary market (although a growing number of sophisticated non-traditional investors are also now participating in the secondary market).

Industry estimates suggest that the secondary market transaction volume reached approximately US$90-100 billion in 2021.

The J-Curve

As a result of drawdowns to fund new investments, management fees and fund expenses, PE Fund investments tend to exhibit negative net cash flows in their initial years. In the later years as the investee companies mature and are subsequently sold for a profit, the fund starts to record positive net cash flows. The collective cash flow pattern is commonly known as the "J-Curve" (Fig. 7).

Purchasing LP interests in the secondary market allows an investor to gain exposure to PE Funds at differing stages in the funds' lives. The initial negative net cash flows can potentially be mitigated by investing in mature PE Funds as shown in the boxed area.

Fig 7: The Private Equity J-Curve