Investing in private equity (PE) and venture capital (VC) funds can be a daunting experience, especially for those not familiar with the jargon unique to this industry. These terms can make the process more daunting and confusing than it really is
In this article, we'll break down some of the key terms in PE and VC explaining who the different players are, how capital is treated, fees, and returns. Whether you are new to the world of investing in PE and VC funds or an experienced fund investor, this post seems to demystify some of the terms that have traditionally kept access to PE and VC gated.
The Players
Limited Partners (LP): This is the investor in a fund who has "limited liability" for the partnership's debts and obligations. LPs provide capital to the partnership and share in the profits or losses of the partnership according to the terms of the partnership agreement.
General Partners (GP): These are the PE and VC fund operators who have "unlimited liability" for the partnership's debts and obligations. GPs are responsible for the day-to-day management of the partnership and make decisions on behalf of the partnership.
Portfolio Company: The portfolio companies are the actual companies in which the GP invests. The GP is responsible for identifying companies in which the fund would like to invest and deploying LP capital commitments to that portfolio company.
Treatment of Capital
Capital Commitment: The amount of capital that a limited partner agrees to contribute to the PE or VC fund over a certain period of time. Note that often this capital commitment is not made all upfront and may be made over time. These payments over time are called "capital calls".
Capital Calls: As the fund identifies and invests in portfolio companies, they will require limited partners to transfer some of their capital commitment to the fund for the investment. This is called a capital call. Capital calls typically occur when the partnership needs additional funds to make investments or cover expenses.
Fund Close: The point at which a private equity partnership stops accepting new investors in to the fund. Note that typically there are multiple closes over the course of 18 months or less as the fund beings to deploy capital while they also continue to raise. Final close is typically a milestone in the fund lifecycle and is often accompanied by additional capital calls.
Co-Invest: The practice of limited partners investing directly alongside the general partner in a specific investment. Some funds make co-investment a deliberate part of their strategy and others may offer no co-investment at all. Co-investing allows LPs to take a more active role in the investment process and can result in net lower fees and higher returns.
Fees
Management Fee: A regular fee paid by LPs to the GP, generally a percentage of committed capital or assets under management. It is paid regardless of the GP's performance and is typically used to offset the GP's operating expenses. A 2% management fee is common.
Carried Interest: Commonly referred to as "carry", the share of the partnership's profits that the GP receives in addition to the management fee. The carry is typically a percentage of the profits. It may involve a "hurdle" meaning carry is only charged on the returns over a certain benchmark, often 8%. These fees are only paid if the fund performs well for LPs and exact terms vary across funds. 20% carry is common.
Clawback: A provision in a partnership agreement that requires the general partner to repay previously received carry if the partnership's overall profits do not exceed a certain threshold. The clawback ensures that the GP does not receive an unfair share of the profits.
Returns
Waterfall Distribution: The method of distributing profits in a partnership that prioritizes payments to either the general partner or limited partner. In an American waterfall returns are distributed first to the GP then LPs and in a European waterfall returns are distributed proportionally between the GP and LPs. The waterfall structure is typically outlined in the partnership agreement.
Distributions: Payments made to LPs from the profits of the partnership, typically when a portfolio company is sold but also potentially from dividends or interest. Distributions are typically made on a periodic basis, such as quarterly or annually, and are proportional to the LPs' ownership percentage in the partnership. Distributions may not be made until several years in to the fund's life.
Illiquidity: Illiquidity is the lack of ability to sell an investment quickly. This is an important factor of PE and VC fund investing that is crucial to understand and very different from public stocks. Investments in private equity partnerships are typically illiquid, meaning that LPs may be required to hold their investments for the entire lifetime of the fund. Typically LPs will hold on to your ownership interest of the PE fund until all returns have been fully distributed.
K-1s: The name of the tax forms that are sent to limited partners in a partnership, reporting their share of the partnership's income, gains, losses, and deductions. LPs use the information on the K-1 to report their share of the partnership's income on their personal tax returns.