As an initial matter, it is important to understand that private equity funds are very different from mutual funds. When an investor invests in a mutual fund, the investor will write a check on day 1 and at some point later in time will withdraw money from the fund. Private equity funds operate on a very different basis - known as a "called capital" basis. Let me explain.
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Example of The Impact of Cash Drag on Returns
Let’s assume you invest $100 in an opportunity that returns $150 four years later. This is shown by the table below:
But what if the $100 wasn’t needed all at once? What if the investment was needed over a period of time? The table below shows the impact if the investment is made over four annual installments of $25 each. The IRR improves significantly, to 17%.
Committed Capital; Called Capital; Capital Calls
When a private equity fund is raised, investors will “commit” to making a total investment in a fund, which is also called a “capital commitment.” The total amount of all investor commitments is called the fund’s “committed capital,” which is also what is referred to as fund size. The investment is not made up front, but is made over time as the fund needs capital.
When the fund needs capital, the fund will notify the investors that it is “calling” capital from the investors (a “capital call”). The total amount of capital that has been called by a fund at any given time is called “paid in capital” or “called capital.” The metric “paid-in-capital” or “PIC” is used for a variety of measurements to evaluate the performance of private equity funds. For a more detailed discussion of Committed Capital, Called Capital, etc., please see my prior blog post here.
Usually, on day 1 of a fund’s life, the fund will call come capital from its investors (also known as “limited partners” or “LPs”). The amount of this capital call will vary from fund to fund. The fund will then make a series of capital calls over the life of the fund in order to make investments, pay management fee and also pay for fund expenses. Thus, LPs will be making cash payments to the fund each year for many years.
Example: Growth Capital Fund I, L.P.
Growth Capital Fund I, L.P. (the “Fund”) is a growth equity fund formed to invest in technology companies. The Fund has received commitments from LPs for $100 million (this means that the fund’s total committed capital (or fund size) is $100 million). The Fund has a 10 year term, with two one-year extensions at the option of the fund’s general partner (“GP”), for a total term of 12 years. For a detailed discussion of fund structure, see my blog post here and for a more detailed discussion of fund terms, see my blog post here. The Fund expects to invest in 15 to 20 companies over a five year investment period, and then realize the investments (also called “harvesting” the investments) over the remaining term of the fund.
During the first year, the Fund calls 15% of committed capital or $15 million dollars, to make investments and to pay management fee and fund expenses. This means that in this first year, LPs will have paid cash of $15 million to the Fund, leaving another $85 million still available to call.
In the second year, the Fund calls 20% of committed capital, or $20 million for more investments, management fee and Fund expenses. The table below shows the capital calls paid by the LPs to the Fund by year.
The chart below shows the capital calls. Note that the calls are red bars to signify a cash outlay.
As a private equity fund makes investments in companies, these companies become known as “portfolio companies” of the fund. Depending on the fund’s strategy (venture capital, growth or buyout), the fund can expect to hold its investment (the “holding period”) in a portfolio company for 3 to 7 years. Usually early stage venture capital funds will have longer holding periods for their investments than for growth equity or buyout funds, as these early stage companies may take a long time to grow to a point where the fund can exit its position.
When a fund sells its stock in a portfolio company and receives cash, the fund has a decision to make. Should it keep the cash on hand for an investment, management fees or fund expenses, or should it give the money to LPs. Giving money back to the LPs is known as a “distribution.” As the previous cash drag example shows, keeping cash at the fund level when it isn’t needed will hurt the fund’s returns. So it is better for a fund to only keep a minimum amount of cash on hand (for near-term management fees, expenses and imminent investments) and to distribute the excess cash back to LPs. Because the fund can continue to call capital from the LPs (until total calls equal the total committed capital of the fund) , the fund can manage its cash flows to maximize its rate of return.
Example: Growth Capital Fund I, L.P.
Going back to our hypothetical fund example, let’s assume that the Fund makes no distributions to LPs in years 1 and 2. This is because the Fund is making investments and the investments will need some time to mature to the point that the Fund can sell its stake in the portfolio company. In years three and beyond, the Fund begins to realize its investments and makes distributions to its LPs as follows:
As the table above illustrates, distributions to LPs typically start a few years out, and generally continue through the life of the fund. Note that the distributions in the above table are positive, to reflect that these are cash inflows to the LPs. The chart below shows distributions in green by year.
Fund Net Cash Flows
The combination of capital calls (LP cash outflows to the fund) and distributions (LP cash inflows from the fund) equal the LP net cash flows to a fund.
The timing of calls and distributions will vary by fund and by strategy (and sometimes will vary greatly). Generally speaking, as discussed above, capital calls are generally heaviest in the investment period of the fund, and then taper off as the fund moves into harvest mode. Distributions are generally light during the investment phase, and are predominant during the fund’s harvesting phase.
Because the fund is managing calls and distributions to minimize cash drag and maximize its returns, there will be a series of calls and distributions over the life of the fund.
Example: Growth Capital Fund I, L.P.
Using our example again, the following chart shows the net cash flows for the Fund.
The chart below shows the cumulative cash flows for the Fund.
The above chart also demonstrates that the LPs net a total $100 million in gain from their $100 million investment. The LPs invested $100 million and the fund returned $200 million, resulting in $100 million in gain.
The cash flow structure for private equity funds has many implications for LPs:
- Uncertain timing and size of capital calls. While it can generally be said the bulk of capital calls will occur during a fund’s investment period, the actual timing and size of calls is unknown.
- Uncertain timing and size of distributions. While it can generally be said that the bulk of distributions occur after the investment period and during the harvest period, the actual timing and size of distributions is unknown.
- LPs must keep cash or near-cash instruments sufficient to meet capital calls. Because the timing and size of calls is unknown, LPs must be prepared to meet capital calls at any time. Calls are typically due 10-15 days after a fund issues a call notice to LPs, and so LPs must prepare for this. Some LPs liquidate public stock holdings to fund capital calls, and this can be a dangerous practice if there is a severe market downturn. Fund calls don’t stop during times of economic or stock market stress, and LPs must be able to continue to meet capital calls.
- The Great Recession. During the great recession of 2008-9, when the stock market plummeted, LPs continued to receive capital calls from funds. This created severe stress for some LPs, which had to liquidate depressed public stocks and bonds to meet capital calls from their various private equity fund investments.
Prior post on fund structure, LPs and GPs:
Prior post on committed capital, called capital, etc.:
Prior post on fund terms:
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