This is second part of the post on dilution.  The first post discussed ownership dilution, also known as equity dilution.  The first post can be found here:  http://www.allenlatta.com/allens-blog/dilution-part-one-understanding-ownership-dilution
 
As discussed in part one, I view dilution as having two components: ownership (equity) dilution and value dilution.  These concepts are related.  Let’s now explore value dilution.

​The word “dilution” is used often private equity, particularly in venture capital financings.  One can hear venture capitalists and founders say they don’t want to be diluted.  But what are they talking about when they say this?  That’s the topic of this post.
 
I view dilution as having two components: ownership dilution and value dilution.  These concepts are related.  In this post, we’ll take a look at ownership dilution.  We’ll look at value dilution in a later post.

What can you learn from reviewing over a thousand private equity fund presentations (also known as “pitch decks”)?  Among other things, you learn what works in a fund presentation and what doesn’t.  This post contains my thoughts on what an emerging manager should include in a fund presentation. 

A fund secondary transaction occurs when an existing investor in a private equity fund sells its interest to a third party in a private transaction.

While this may sound pretty straight-forward, fund secondaries are fairly complex.  One complexity relates to the fact that an investment in a private equity fund is "illiquid."  It is called illiquid because it isn’t very easy for an investor in a private equity fund to sell its fund interest.
 
There are several reasons why interests in private equity funds are illiquid.  First, unlike publicly-traded stocks which can be bought and sold very easily on public markets like the New York Stock Exchange and NASDAQ, there is no public market where one can buy or sell interests in private equity funds.  Second, for stocks to be able to be sold on public markets like the New York Stock Exchange and NASDAQ, by law they must first be registered with the US Securities and Exchange Commission (“SEC”).  Interests in private equity funds are not registered with the SEC, and so there are legal (statutory) restrictions on the sale or transfer of these fund interests.  Third, investors in private equity funds sign contracts (known as “limited partnership agreements” or “LPAs”) which contain restrictions on the sale or transfer of the fund interests.

​In my prior post, “LP Corner: Understanding the “Equity” of Private Equity” we explored the “Equity” in Private Equity.  In this post we explore the “Private” in Private Equity.  These posts are complements to my initial post “LP Corner: What is Private Equity?”.  The hope is that these posts will provide the reader with a good overview of what “Private Equity” means.
 
So what does the “Private” in Private Equity mean?  In essence, it means that the companies that PE funds (buyout, venture capital and growth equity funds) invest in and/or acquire are privately-held companies.  To understand this, first we'll explore what public companies are, and then we'll take a deeper dive into what private companies are, and we'll finish with a discussion of the types of companies that buyout funds acquire..

​Private equity, generally speaking, is an equity (stock) investment in a privately-held company.  My blog post “LP Corner: What is Private Equity?” provides an overview of how the term “private equity” is used.  This post is going to explore the “equity” component of “Private Equity.”  This post is a complement to my posts "LP Corner: What is Private Equity" and "LP Corner: The "Private" in Private Equity".
 
Let’s start with a basic definition of equity: Equity is the most basic form of ownership in a company.  Since virtually all private equity-backed companies in the United States are corporations, we are going to focus on equity in a corporation.

To all readers: I hope you and your families are healthy and safe.  My thoughts are with all who are impacted by this deadly virus.
 
I’ve been around for a while, and have experienced several market dislocations in my career.  I had just started my career as a corporate finance attorney when the “Black Monday” stock market crash of October 19, 1987 occurred.  I was a telecommunications investment banker when the dot-com crash occurred in March 2000.  I was a private equity fund-of-funds manager when the Global Financial Crisis (“GFC”) hit in 2008.  Because of these experiences, I have some thoughts for limited partners (“LPs”) during this crisis.

​A concept that is important for understanding company financings is that of “pre-money” and “post-money” valuation.  Pre-money valuation is the value of a company immediately prior to a financing round.  Post-Money Valuation is the value of the company immediately after the financing round.  The difference is usually the amount of money raised in the round.
 
Let’s explore this deeper.

​In April 2005, my article “An LP’s 10 Tips for Emerging Managers” appeared in the Venture Capital Journal.  This article offered advice to new managers on how to successfully raise a private equity fund.  With the advantage of many(!) additional years of experience evaluating emerging managers, I thought I should update that advice.  Below are some tips for emerging managers seeking to raise money from potential private equity fund investors (also known as “Limited Partners” or “LPs”).

1. Have Sufficient Resources for a Lengthy Fundraise.
Raising a fund takes lots of determination, time and money.  Some people rush into raising a fund without considering whether they have the resources to successfully raise a fund.  Raising a first-time fund can take a long time, in some cases 18 to 24 months (or more), and can cost over $1 million, which the partners of the emerging manager must pay out of their pockets until the fund has its initial closing, at which time fundraising expenses (excluding placement agent fees, see below) are reimbursed by the fund.  The partners must have sufficient resources to finance the costs of fundraising as well as the costs of opening and maintaining an office (with staff).  In addition, each partner of the emerging manager must have enough resources to finance that partner’s personal household expenses during the fundraising.  Having the resources to fundraise for an extended period of time is critical to the success of raising a fund.

My firm Campton Private Equity Advisors today hosted a webinar "Private Equity Investing 101: An Overview for New Investors" which provided an overview of investing in Private Equity.  Topics covered in the webinar included:

• What is Private Equity?
• Introduction to Venture Capital and Buyouts
• Why invest in Private Equity?
• Private Equity investment strategies: direct investing, fund investing and fund-of-funds investing

Click the button below to go to a reply of the webinar on YouTube:

If the button doesn't work, here's a link to the webinar on YouTube at: ​​https://youtu.be/zsFgajgoE2E

The presentation is available for download below:

​Overview
Private equity funds-of-funds (“FOFs”) ​are funds that invest in other private equity funds, which then invest directly into privately-held companies.  By investing in a FOF, a limited partner (“LP”) obtains a diversified portfolio of private equity fund investments as well as a larger portfolio of indirect investments in underlying private companies.  I have worked for two private equity fund-of-fund managers and understand well the pros and cons of these vehicles.  This post provides an overview of FOFs.
 
Structure
FOFs invest in a portfolio of private equity funds (known as “portfolio funds”), which in turn invest in privately-held companies (known as “underlying portfolio companies”).  A FOF will invest in a portfolio of private equity funds and each portfolio fund will invest in a portfolio of private companies.  As a result, an LP’s single investment in a FOF can provide the LP with exposure to many funds and potentially hundreds of underlying portfolio companies.  The simplified diagram below illustrates this.

I will be speaking at the upcoming PartnerConnect Midwest private equity conference in Chicago June 24-26.  I will be speaking on the panel "Better Your Benchmarks: The Latest Strategies and Techniques You Need to Know to Assess Your Investments' Relative Returns."

Here's a link to the conference website: https://partnerconnectevents.com/pcmidwest2019/index.php

Please stop by and say hello if you're at the conference.

Just as wines have “vintage years”, private equity funds also have "vintage years."  But what is a vintage year?  For wine, it’s universally recognized as the year the grapes were harvested.  However, it’s not that simple for private equity, as various industry participants define “vintage year” differently.

Consider the following hypothetical:  In 2011, two private equity professionals decide to raise a fund.  That year they form a legal entity for the fund and launch their fundraising efforts.  In late 2012 the fund has its initial closing of commitments from limited partners, and makes its first capital call, where limited partners make their first cash contribution to the fund.  In 2013, the fund makes its first investment.  In 2014, the fund has its final closing.  As of September 30, 2018, the fund has a net IRR of 18.5%.  What should the vintage year be for this fund - 2011, 2012, 2013 or 2014?

​To read more, please click on "Read More" below.

An important event in the life of a private equity fund is when the fund “exits” its investment in a portfolio company.  An exit is also known as the time when a fund “cashes out” or “liquidates” its investment in a portfolio company.  Exits occur in three main ways: (1) the portfolio company is sold and the fund receives cash or publicly-traded securities for its shares in the portfolio company; (2) the portfolio company holds its initial public offering, or IPO, and the fund later sells its shares in the portfolio company on the public market or the fund distributes the publicly-traded shares to the fund’s limited partners; and (3) the fund sells its shares of a portfolio company to another investor in a private transaction (this is known as a direct secondary sale).  While there are other ways a fund can achieve a full or partial exit, the above exit routes are the main ways a fund achieves liquidity.
 
We have discussed IPOs in prior posts (see for example: LP Corner: What LPs Need to Know About IPOs).  In this post, we will discuss some of the things about the sale of a portfolio company that LPs should know.
 
Common M&A structures.
The sale of a company can take many different forms.  The most common sale structures are:

• Stock for Cash
• Stock for publicly-traded stock
• Stock for privately-traded stock
• Asset sales
• Mergers

The type of structure can have an impact to a limited partner in a fund (“LP”) in terms of how and when the LP may receive a distribution from the fund relating to the transaction.
​
To read more, please click on "Read More" below.

Why is it that mutual funds take an investor’s capital on day 1, while PE funds take an investor’s capital over time?  That’s the topic of this post.

When an investor makes an investment in a mutual fund, the investor invests the entire amount of the investment on day 1.  The mutual fund manager will quickly use this money to increase existing positions in the fund or make new investments.  It’s easy for the mutual fund manager to put the money to work by buying publicly-traded securities.
 
Investments in private equity funds are different.  Private equity funds operate on a “called capital” model.  By way of background, when an investor (known as a “limited partner” or “LP”) makes a legal commitment to a private equity fund, the LP commits to providing the fund with a certain maximum investment amount, which is known as the “LP commitment.”  For example, if an LP agrees to invest a total of $10 million in a private equity fund, that $10 million is the LP commitment.  For more background, please see the following posts:

• LP Corner: On Committed Capital, Called Capital and Uncalled Capital
• LP Corner: US Private Equity Fund Structure – The Limited Partnership

 
​To read more, please click “Read More” below.

Sit right back and you’ll hear a tale…
 
In this fictional account, Able Bentley Capital is a $500 million private equity fund (“ABC”).  ABC is formed as a Delaware limited partnership, and the general partner (“GP”) is ABC Partners.  (For a discussion of limited partnerships, see my post “LP Corner: US Private Equity Fund Structure - The Limited Partnership.”)  ABC makes a number of international investments.  Bill Smith is one of managing partners of the management company and a member of the GP.  Bill sources and leads several international investments.  It is common in international investments to have the fund’s investment flow through one or more intermediate (known as “blocker”) shell companies in order to shield the fund from negative tax consequences.  Using a complicated blocker structure, Bill was able to defraud ABC out of several million dollars.  The fraud was eventually discovered and after several years Bill was convicted of fraud and embezzlement.
 
Situations where a GP (or a principal of the GP or management company) behave truly badly are rare, but they do occur.  The question becomes, what should happen when really bad behavior occurs?  Read on to find out!
 
To read more, please click “Read More” below.

Divorce, Private Equity style...

Private equity funds have long lives.  Private equity limited partnership agreements (LPAs) typically provide for an initial 10-year term, plus two one-year extensions at the discretion of the general partner of the fund (GP).  However, fund terms often stretch out for much longer, sometimes 15 to 18 to 20 or more years.  This is truly a long-term commitment, for both the limited partners (LPs) and for the GP.  For an overview of LPs, GPs and limited partnerships, please see my prior post "LP Corner: US Private Equity Fund Structure - The Limited Partnership."
 
Because funds stay around for a long time, things will change.  Partners may leave the fund’s management company; the investment strategy might drift away from the initial strategy; the investment performance may be terrible to the point that the LPs want to stop the GP from investing; the fund or management firm may be embroiled in a scandal; or in rare cases, the GP may behave badly (not illegally or in violation of the LPA, but in ways that may place their personal interests above the best interests of the LPs).  There are many other changes that can occur during the life of a fund.

To read more, please click "Read More" to the right below.

Thousands of private equity funds are being raised right now.[1]  For a fund in the market, that’s a massive amount of competition.  Limited partners (or LPs), the investors in private equity funds, are constantly meeting with general partners (GPs), the fund managers, to select the very best funds in which to invest.

This means GPs have little room for mistakes on the fund-raising trail.  A compelling roadshow is a key element to fundraising success.

Having met with hundreds of managers over the years, and after seeing the good, the bad and the ugly of roadshow presentations, I offer the following thoughts for GPs on how to have a successful roadshow meeting with an LP.
This article is geared to funds that will be institutional – $100 million or more marketing to institutions including pension funds, funds of funds, foundations, endowments and family offices. But most of the tips presented will also be relevant for sub-$100 million funds.​

This is one of a series of posts on fund terms.  Other posts in this series include:

• Management Fee
• GP Commitment
• Carried Interest Overview
• Carried Interest – Preferred Return and GP Catchup
• GP Clawback
• Management Fee Offsets
• No Fault Divorce
• For Cause Actions
• Should Venture Capital Funds have a Preferred Return Hurdle?

When an LP invests in a fund, it is because the LP believes that the investment team will successfully invest the fund.  But what happens if members of that investment team leave the firm in the midst of investing?  What happens if a key member of the team dies, or is convicted of securities fraud?  A “key person” clause (historically known as a “key man” clause) provides LPs with protections in case these events, and others, occur.

To read more, please click on the "Read More" link below and to the right.

Why is it that most buyout funds, many growth equity funds and few venture capital funds have an 8% preferred return hurdle?  Why should there be a difference among the different strategies?
 
What is a preferred return hurdle?
A preferred return hurdle is a component of the fund manager’s carried interest. 
 
​To read more, please click on the "Read More" link below and to the right.

This is one of a series of posts on fund terms.  Other posts include:

• Management Fee
• GP Commitment
• Carried Interest Overview
• Carried Interest – Preferred Return and GP Catchup
• Management Fee Offsets
• Key Person Clauses
• No Fault Divorce
• For Cause Actions
• Should Venture Capital Funds have a Preferred Return Hurdle?

In this post, we will explore what happens if the GP is paid too much carry.  Generally speaking, the GP must return the overpayment, and this is called the GP clawback.  But it’s not that simple, so read on!
 
How a GP Can be Paid Too Much Carry
In the prior post “LP Corner: Fund Terms – Carried Interest Overview” we discussed that there are two main types of carried interest – whole fund carry (also known as “European carry”) and deal-by-deal carry (also known as “American carry”). 
 
In whole fund carry, the GP is paid carry only after the fund has returned to the LPs all of their contributed capital.  This has the effect that the GP is paid carry later in the fund’s life (compared to deal-by-deal carry), and because the LPs are repaid all of their contributed capital before the GP takes its carry, it is pretty unlikely that the GP will receive too much carry. 
 
Conversely, in deal-by-deal carry, the GP can collect carry much earlier than under whole fund carry, and in some cases, the GP can be paid too much carry over the life of the fund.  Please review the example in the prior post for more detail on this and to see how too much carry can be paid.
 
To read more, please click on the "Read More" link below and to the right.

This is one of a series of posts on fund terms.  Other posts include:

• Management Fee
• GP Commitment
• Carried Interest Overview
• ​GP Clawback
• Management Fee Offsets
• Key Person Clauses
• No Fault Divorce
• For Cause Actions
• Should Venture Capital Funds have a Preferred Return Hurdle?

In this post, we will explore two items relating to carried interest: preferred return and GP catchup.
 
Preferred Return Hurdle
A preferred return (or “hurdle rate”) is a minimum threshold return that LPs must receive before the GP can receive its carried interest (or “carry”).  The preferred return is usually expressed as a percentage return per year, and in private equity that is usually 8% per year.  This means that the LPs must receive an 8% annual return on their contributed capital before the GP can receive carry. 
 
GP Catchup
There are two types of preferred return hurdles: (1) a “pure preferred return” (also known as “hard preferred return”); and (2) a preferred return with GP catchup. 
 
Pure Preferred Return Hurdle.  In the pure preferred return hurdle, the GP only receives carry on gain in excess of the preferred return hurdle.  This has the impact of reducing the carry the GP receives over the life of the fund.  The pure preferred return hurdle is not used in private equity. 
 
Preferred Return with GP Catchup.  In a preferred return with GP catchup, once the preferred return hurdle is met, the GP receives all or most of the future profits until the GP catches up to its 20% carry amount, and after that the profits are split 80% to the LPs and 20% to the GP (for its normal carry).  The preferred return with GP catchup results in the GP receiving its entire 20% profit share.  This version of preferred return hurdle is the norm in the private equity industry.

To read more, please click on the "Read More" link below and to the right.

This is one of a series of posts on fund terms.  Other posts include:

• Management Fee
• GP Commitment
• Carried Interest – Preferred Return and GP Catchup
• GP Clawback ​
• Management Fee Offsets
• Key Person Clauses
• No Fault Divorce
• For Cause Actions
• Should Venture Capital Funds have a Preferred Return Hurdle?

Carried Interest Overview
As discussed in my prior post on management fee, the long-standing fee model for private equity funds has been a “2 and 20” model, referring to a 2% management fee and a 20% carried interest.  But what is this “carried interest?” 
 
Read on!
 
Carried interest, also known as “carry,” “profit participation,” “promote” or the "distribution waterfall," is the share of the fund’s profit the fund’s manager (also known as “general partner” or “GP”) earns if the fund returns a profit to the fund’s investors (also known as “limited partners” or “LPs”).  See my prior post "LP Corner: US Private Equity Fund Structure - The Limited Partnership" for more detailed descriptions of LPs and the GP.
 
When a private equity fund calls capital from its LP investors (this is known as “paid-in-capital’ or “called capital” - see my prior post "LP Corner: On Committed Capital, Called Capital and Uncalled Capital" for further discussion of this topic), the GP manager of the fund will use that capital to make investments and to pay for fund expenses, such as management fee.  When the investments are realized, the amount in excess of the original investment amount is profit. 
 
The Two types of Carry: Whole Fund and Deal-by-Deal
There are two main types of carry: whole fund carry and deal-by-deal carry. 
 
To read more, please click on the "Read More" link below and to the right.

This is one of a series of posts on fund terms.  Other posts include:

• ​GP Commitment
• Carried Interest Overview
• Carried Interest – Preferred Return and GP Catchup
• GP Clawback
• Management Fee Offsets
• Key Person Clauses
• No Fault Divorce
• For Cause Actions
• Should Venture Capital Funds have a Preferred Return Hurdle?

In private equity, the term “2 and 20” refers to the traditional compensation structure for private equity funds: 2% management fee and 20% performance fee (also known as “carried interest” or “carry”).
 
In this post, we will explore management fee.
 
Historically, management fee was intended to provide fund managers with enough money to pay modest salaries, rent modest offices and incur modest expenses.  It was said that management fee was intended to let the fund manager “keep the lights on” and that the performance fee (known as “carried interest” or “carry”) was where the fund manager made its money.  While investors in private equity funds (known as “limited partners” or “LPs”) continue to take this view, terms in fund documents (known as the "limited partnership agreement" or "LPA") relating to management fee have become more complex.
 
Let’s dig in.
 
In previous posts, we have explored committed capital and the investment period:

• LP Corner: On Committed Capital, Called Capital and Uncalled Capital
• LP Corner: the Four Phases in the Life of a Private Equity Fund
• LP Corner: Private Equity Cash Flows from the LP Perspective

 
We will look at management fee in three phases of a fund’s life: the investment period, the harvesting (or realization) period and during extensions.

To read more, please click on the "Read More" link below and to the right.