Investing in private equity funds is a long-term process. Private equity funds have finite lives, unlike mutual funds. Most private equity funds come to market with a 10 year term with up to two one-year extensions at the discretion of the manager. This suggests a fund term of 10-12 years. However, most funds exist for much longer than 12 years from the initial call of capital to final liquidation.
I view the life of a private equity fund as having four phases:
- Formation;
- Investment;
- Harvesting; and
- Extension.
The four phases of a fund’s life can be viewed graphically:
To read more, please click on "Read More" to the lower right.
Let’s examine each phase.
Formation. The fund technically doesn’t exist until the very end of this phase. The Formation phase is when the partners develop the fund's strategy, prepare the offering materials, fundraise, negotiate fund documents and then voilà – a fund is born!
The fund formation stage is fraught with peril, especially when the fund is a first effort from a new management team – known as an “emerging manager.” Fundraising takes a lot of time and effort – a fundraising process can range from a few months (for established managers) to a few years (for an emerging manager). During this time, the partners are preparing their offering materials, meeting with potential investors (known as “Limited Partners” or “LPs” – see my prior post on fund structure) and their advisors, answering due diligence questionnaires and requests, and trying to drive LPs towards an initial closing for the fund – a process often likened to “herding cats.”
During this time, the partners are also developing a deal pipeline (deal flow) and in some cases may make investments that will roll into the fund when (and if) the fund closes. These investments are known as “warehoused” investments, and can help to demonstrate the fund’s investment process to potential LPs.
Finally, during this time, the partners are incurring expenses in connection with fundraising and forming the fund (travel, legal, etc.). These expenses will typically be reimbursed to the partners when the fund closes (up to a cap), but if the fund doesn’t close, the partners are on the hook for these expenses.
Investment. Once the fund’s legal documents are signed, the fund is “born” and the fund life (or fund term) time clock starts ticking. Most funds provide for a 10 year term, with up to two one-year extensions at the option of the general partner of the fund (known as the “GP” – see my post on fund structure for more).
The first three to five years of the fund’s life are known as the “Investment Period.” The Investment Period is the most active period in a fund’s life. During this time the GP is sourcing and evaluating potential investments, conducting business and valuation due diligence, negotiating term sheets, and closing deals. This period of time is when the fund invests in its core portfolio companies.
Depending on the fund’s strategy (buyout, growth equity or venture capital), additional capital may be required by a portfolio company (a company in which the fund has made an initial investment). This is most common in early-stage venture strategies. When venture capital funds invest in early stage companies, the investment round provides the company with enough capital to reach certain milestones. After the company reaches these milestones, another round of funding occurs. This process repeats until the company either holds its initial public offering (“IPO”) or is acquired (typically by a strategic buyer, but sometimes by a financial buyer). When a fund makes an initial investment in a fund, the GP will allocate (or “reserve”) additional capital for expected follow-on financing rounds. This is a prudent strategy, as if the fund lacks the capital to make further investments in a portfolio company, the venture fund can suffer both ownership and valuation dilution. Some of the follow-on financing rounds may occur during the Investment Period, but also occur during the Harvesting phase.
The time from an initial investment to exit (when the fund sells its position in the portfolio company) can range from a very short period of time (months) to a very long time (10 to 15+ years). For buyout strategies, the “hold” time for an investment is targeted to be between three and five years, but the actual hold time can be much longer. In my experience, the average hold time for a buyout investment can range from 5 to 6 years. However, some companies may not perform as expected, and as a result the holding period for an under-performing company may exceed 10 years.
During the investment period, the fund is paying the headline management fee, which is typically 2% of fund size (this is known as committed capital). For example, if a fund has $100 million of capital commitments, the fund will pay the GP $2 million per year (usually on a quarterly basis at the beginning of the quarter) to manage the fund.
Often, private equity firms will start raising a new fund as soon as the existing fund has finished making its initial investments. This may lead to a situation that the private equity firm is receiving management fee from the existing fund at the same time it is receiving capital from a new fund.
Harvesting. Once the Investment period has expired, the fund will be finished with making initial investments, and will focus on helping the portfolio companies grow and succeed and on exiting its investments. The manic pace of the Investment period slows in the Harvest phase as the GP focuses on the existing portfolio. In fact, fund legal documents often specify that no new investments may be made after the expiration of the Investment period (but additional investments in existing portfolio companies are allowed).
During the harvest phase, the focus is on growing the investments and exiting. Growing an investment may require additional investment in an existing portfolio company – known as a “follow-on” investment.
Some portfolio companies may hold their initial public offerings, while others will be acquired. For buyout strategies, some of the portfolio companies may undergo a dividend recapitalization ( a financial process where a portfolio company refinances its debt and borrows a bit more, which additional capital is used to pay a dividend to the buyout fund).
The Harvest phase is typically less labor intensive than the Investment phase. In my view, the management fee paid to the GP should be lower in this phase of the fund’s life than during the Investment phase. Indeed, many fund documents provide for a “step-down” in management fee during the Harvest phase.
While the stated fund term is 10 years, the GP does have two one-year extensions that the GP can use if the fund still has portfolio companies to manage.
Extension. In my view, the Extension phase starts when the initial fund term has ended, which is usually 10 years. As stated above, the GP typically has the right to extend the fund for up to two one-year periods. This extra time is intended to provide the GP with a window to exit the final portfolio companies, and wind-up and dissolve the fund.
However, it is becoming more common for GPs to ask LPs for even more time to manage out the investments in the fund. For early-stage venture strategies, there may be companies that have not had the explosive “hockey stick” growth expected from venture investors. These slow-growing companies are often called “zombie” companies.
During the extension period, the GP will continue to work to liquidate its holdings in the remaining portfolio companies. Also, an occasional follow-on financing may occur for a portfolio company. There may also exist some legacy escrows or earn-outs that were part of prior acquisitions of portfolio companies that may take a year or two to be paid.
The difficulty I have with funds in extension is a misalignment of interests that can occur between the GP and the LPs. An example of this is the payment of management fee. In my view, after 10 years of receiving management fee, the GP should not expect to be paid a fee during the Extension period. Practically speaking, if the GP has the right to extend the fund’s term for up to two years, the GP will likely receive management fee during these two years (for a total of 12 years of management fee!), but after that my view is that management fee is inappropriate. I have been on advisory boards of funds in extension, and management fee during extensions is often a touchy subject.
As an aside, may people call funds in extension "tail-end funds." The term "tail-end" is used in a variety of ways. Sometimes it is meant for funds that are late in their Harvest phase (8-9 years old) or sometimes it is used to describe funds in extension. I've also seen the term "tail-end fund" refer to funds that have less than a certain value of remaining assets or investments.
Final Thoughts. In my experience, the life cycle of a fund (from inception to final liquidation) is growing longer. For early stage venture strategies, it is not uncommon to see funds that are 15-20 years old. For investors new to investing in Private Equity, this is something that should be carefully considered.
Comments?
