Thinking of investing in private equity? Here are ten terms you need to know.
We unpack ten private market terms that are fundamental to understanding the asset class.
Previously the domain of large institutional investors, private markets are becoming increasingly accessible to intermediaries and individual investors – the so called ‘democratisation’ of private assets.
They’re important because they can provide alternative sources of returns for investors, can serve to diversify a portfolio as they are often less correlated with traditional asset classes, and tend to be less volatile than publicly-traded assets.
While the nature of transactions can be complex, the terminology needn’t be. Here, we demystify ten essential terms for investors getting to grips with private markets.
1) Private assets: Investments that are not publicly listed or traded.
Broadly speaking, there’s private equity, which is an ownership stake in an unlisted/non-public company, and private debt, which is a loan held by or extended to a privately-held company.
Private equity investors hope that by investing in a private company they can make it more valuable - by improving efficiencies for example - and sell their holding at a later stage.
Meanwhile, private debt tends to be issued to companies or assets that need more flexible financing terms than are available to them from banks.
Other types of private assets include infrastructure and real estate.
2) Venture capital (VC): A private equity strategy that provides minority financing to fast-growing and young start-up businesses in exchange for an equity stake.
Within a portfolio of companies backed by VC, it is generally assumed that most returns will come from a few stand-out performers.
3) Growth equity: Another private equity strategy, in which investors finance a fast-growing, but more mature company with the potential for significant further growth, in exchange for a minority stake in the business.
4) Leveraged buyout: Majority/control equity investments into a well-established company using debt to finance the transaction (LBO).
5) Turnaround: Financing provided to a company at a time of operational or financial difficulty with the intention of improving the company's performance.
6) General vs limited partners of a PE fund: General partners (GP) are investment professionals responsible for managing the fund. They typically commit a smaller initial sum to set up the fund, have unlimited liability and are generally paid a management fee – some proportion of the fund’s invested capital.
Limited partners (LP) are the external investors that provide the capital for private investments. Their liability is limited to the amount they have invested. GPs often work with LPs with whom they have an established relationship.
7) Closed vs open fund: A closed-ended fund is the more traditional structure for private market funds. They have a fixed term, which is typically 10-15 years or longer, in which to raise, invest, earn and distribute capital.
By contrast, an open-ended fund doesn’t have a defined term so it can continue to operate, raising, investing, earning and distributing capital, until it’s actively shut down. Investors aren’t locked in for the duration of the fund’s term – they can liquidate their holdings during a ‘liquidity window’.
8) Liquid, semi-liquid and illiquid: While private markets in general are considered illiquid (i.e. you can’t easily buy or sell your investments), funds can provide varying degrees of liquidity.
A liquid, open-ended fund is a rare beast in private markets. One of the main issues is that managers would have to keep high levels of cash to meet liquidity needs, which may drag on performance.
Semi-liquid open-ended funds feature monthly or quarterly subscription and redemption cycles. They often use tools such as redemption caps or the possibility to suspend subscriptions and redemptions so the manager can better control liquidity within the fund.
Semi-liquid closed-ended funds have a defined term but offer periodic liquidity windows for a managed secondary market.
Closed-ended funds are illiquid, but stakes in those funds can be sold by investors (limited partners) in the secondary market.
9) Capital calls: Investors in closed-ended private asset funds tend to provide capital on an as-needed basis. A capital call is when a fund manager calls on the fund’s investors to provide capital in order to make investments and meet obligations of the fund such as expenses and fees. A capital call is usually made formally in writing.
10) Premia - complexity vs illiquidity: Private assets typically have holding periods of several years or more. Illiquidity is often seen as a disadvantage compared to liquid investments; therefore, the private investor expects to be compensated by a performance premium for their illiquid investment.
The complexity premium is the excess return that can be captured in private assets when rare skills are deployed to manage a complex investment. The nature of the complexity premium differs depending on the type of asset, but unique skills and complexity need to be present for it to emerge.
Interested in learning more about private equity at Schroders?
Click to learn more about the Schroder Specialist Private Equity Fund.
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