What are the Characteristics of Private Equity?

The structure of private equity funds is a fixed limited partnership; therefore early withdrawals are not possible. Moreover, there is often a sales restriction that underlies private equity investments. Private equity investments generally are liquid, because when there is a possibility of a secondary sale of fund shares, investors can expect a substantial discount on the net asset value if selling in the secondary market.

When participating in a limited partnership, the investor needs a minimum amount of capital commitment. This minimum differs from fund to fund, but it is a small fraction of the wealth of an investor. So, the potential for diversification is highly restricted. The private equity market is not transparent. One of the key characteristics in this market is that there is little publicly available information. The lacking of transparency is seen as a necessity for achieving the results, because a substantial part of the returns, private equity experiences, is due to the ability to exploit inside information.

Most private equity funds are structured as limited partnerships and are governed by the terms set forth in the limited partnership agreement or LPA. Such funds have a general partner (GP), which raises capital from cash-rich institutional investors, such as pension plans, universities, insurance companies, foundations, endowments, and high-net-worth individuals, which invest as limited partners (LPs) in the fund. Among the terms set forth in the limited partnership agreement are the following:

  • Term of the partnership: The partnership is usually a fixed-life investment vehicle that is typically 10 years plus some number of extensions.
  • Management Fees: An annual payment made by the investors in the fund to the fund’s manager to pay for the private equity firm’s investment operations (typically 1 to 2% of the committed capital of the fund
  • Distribution Waterfall: The process by which the returned capital will be distributed to the investor, and allocated between Limited and General Partner. This waterfall includes the preferred return: a minimum rate
    of return (e.g. 8%) which must be achieved before the General Partner can receive any carried interest, and the carried interest, the share of the profits paid the General Partner above the preferred return (e.g. 20%).
  • Transfer of an interest in the fund: Private equity funds are not intended to be transferred or traded; however, they can be transferred to another investor. Typically, such a transfer must receive the consent of and is at the discretion of the fund’s manager.
  • Restrictions on the General Partner: The fund’s manager has significant discretion to make investments and control the affairs of the fund. However, the LPA does have certain restrictions and controls and is often limited in the type, size, or geographic focus of investments permitted, and how long the manager is permitted to make new investments.

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