What is Private Equity?

What is Private Equity?

Private Equity is a complicated asset class, which in itself consists of many different types of assets with significantly different risk-reward relationships. One of the most common misunderstandings is the fact that commitments equal actual investments. It does not. Moreover, investment is a lengthy process, and the assets are most often not liquid.

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Liquidity and Cash Flows

Private Equity investments are characterised by the so-called J-curve effect, and it is important to underline this fact. In the graph below we have illustrated this by the mechanics of the 6 following observations.

Committed Capital
Investor A commits a certain amount: Index Capital Amount 100. As it is cash outflow for investor A we have noted the amount in the graph to -100. The committed capital stays at the same level over the life of the investment. Please do not equal Committed capital with Invested capital. These two notions are not the same. Please, refer to Commitment vs. Investment.
Investor A pays a certain amount of its total commitment, as and when called from the investment fund. The time horizon of these gross capital investments is typically a 6-8 years horizon.

As a direct consequence of a realisation in the underlying investment fund, the returns will be re-distributed on a pro-rata basis to Investor A. Distributions will occur until the last investment is realised, thereby closing the fund.

Cumulative Paid-in
Typically the committed capital will be drawn over a 6-8 years period, the cumulative paid-in thereby approaching -100 over that time, by accumulating the net paid-in every year.

Cumulative net cash flow
Similar to the IRR curve, the cumulative net cash outflow deepens in the first years by the accumulated paid-in amounts and is smoothened in year 3, when the first distributions are returned. Typically, the net cash flow position reaches the lowest negative level the year in which the IRR curve turns positive. As from this year, the net cash flow increases every year by the net amount redistributed to Investor A. As can be noted, the maximum net outstanding cash flow is rarely more than 70% of total committed capital. Please refer to Commitment vs. Investment.

Representing the J-curve, the IRR is negative over the first couple of years. Initially the curve is steeply falling as the management fee weighs on the modest actually invested capital with no cash returns as of yet. Please note that actual invested capital is quite insignificant during this time, and that the undrawn capital can be invested alternatively for a positive return until the cash is drawn. Typically, Investor A will get its first cash return in year 3, whereby the J-curve will have bottomed in year 2 and is now trending toward positive, which usually happens in year 4-5. Investor A would then experience a continuously rising IRR until the end of the term for the fund.

Commitment versus Investment

One of the common misunderstandings in Private Equity is that commitments equal investments. They do not. The following simple example of commitment, investment and the time factor is a way to illustrate this crucial point.

Investor A gives a commitment of 100 to a PE fund at inception. The PE fund then makes investments over a period of typically 4-5 years. A fund-of-funds setup usually deploys the money over a further 3-year period. Each investment is financed by a pro-rata cash call on all investors. This continues throughout the investment period of 4-8 years.

Investor A is thus actually investing a smaller part of its total commitment each year, typically increasing in size around year 2-6 and then trailing off again. The first realisation will typically happen in year 3, and the proceeds will be returned pro-rata to the investor. Investor A will therefore receive the first payback on its initial investments years before having made the final contribution. At a certain point in time, the net cash flow position turns positive for the investor, and at end the term of the fund the investor should have a significant positive accumulated net cash position.

This is illustrated in the graph Net Cash Flow. In absolute terms, it is rare that the net cash flow outstanding in any year is greater that 70% of the total commitment for Investor A.

Similarly, the Market Value graph illustrates the balance sheet impact of the investments. As the investments are valued at market value, the market value position of the accumulated investments usually exceeds that of the accumulated Net Cash Flows. Still, only rarely does the accumulated market value exceed the total commitment from Investor A at any point in time. In this graph it reaches a maximum value at 90% of total commitment in year 7.

Fund-of-funds Market Value and Net Cash Flow

Fund-of-funds Market Value and Net Cash Flow

The question is then how to build up a Private Equity position as a percentage of the investor’s balance sheet? We have tried to illustrate the answer in the graph Long Term Build Up of Private Equity Exposure.

In the bottom part of this graph you see the market value graph multiplied every second year. This gives Investor A its underlying exposure at market value reaching typically 90% at the top point in year 7. We assume that investor A commits an amount equalling 50% of its total desired exposure each time.

Long Term Build Up of Private Equity Exposure

Long Term Build Up of Private Equity ExposureRepeating the commitments every second year, the investor builds up investments over several funds, thus accumulating total invested exposure over time. This is illustrated in the Total Exposure graph reaching 100% exposure in year 8

This model, therefore, illustrates that in order to reach 100% of desired investment in private equity assets, the investor must commit 50% every second year. Investor A will then reach the desired invested amount in year 8
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Danske Private Equity has held a first closing of Danske PEP 2018 which targets EUR 500m of total commitments

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