About Private Equity

Private equity investments are an important source of capital for new and emerging firms, distressed firms, and both private and public firms in need of capital. This working capital can be used to nurture expansion, new product development, or restructuring of the company's operations, management, or ownership.

Investments are generally made by a private equity sponsor, a venture capital player or an angel investor and each will have its own goals, preferences and investment strategies. Among the most common investment strategies in private equity are: leveraged buyouts, venture capital, growth capital, distressed investments and mezzanine capital.

About Private Equity

Private equity investors, which include professional venture and buyout funds, institutional investors and high net worth individuals, are often able to provide capital in situations where traditional lenders lack the necessary expertise. Private equity can bring benefits through a company's entirety as investors provide a valuable intellectual and business resource through their expertise and experience.

What is Carried Interest and how does it work?

Carried interest is the portion of the pre-agreed profit split between the investment manager (or related entity) and the other investors which is asymmetric in relation to invested capital and only paid out to the investment manager if the total return exceeds a certain pre-agreed threshold.

A private equity fund is started by the investment manager, often an entity set up by a group of individuals. They take initiative to start the fund, invite a group of passive investors to join the fund, and also invest alongside the other investors. It is important that they invest their own capital in the fund and thus face the same risks as other investors. They also take a specific risk in initiating the fund.

The fund invests in companies; owns and supports their developments; and, after normally 3-7 years, sells the companies. The fund aims to sell the companies at a higher value than they were acquired at. If successful, this higher value is a capital gain providing the fund and its investors an investment return on their investment. This investment return partly accrues to all investors in the fund in proportion to their investment into the fund; and partly, if the fund is very successful, the excess investment return accrues with 20% to the investment manager, and 80% to all investors in the fund. This asymmetric investment return, accruing only in very successful funds with very high returns, is called carried interest.

Private equity investors expect high returns on their investment, before any carried interest accrues to the investment manager (and its owners). First of all the fund must return all capital contributed by the investors. Then it must generate a previously agreed rate of return ("hurdle rate" or "preferred return"). The hurdle rate is most often higher than the expected average return on equity markets. Industry standard is 8%. In addition, the fund must also return all fees and expenses, which in effect frequently increases the hurdle to 11-13%.

The purpose of this is to guarantee that the investment manager has aligned interests with the rest of the investors - they take risks and invest their own money - but also an incentive to achieve for the best possible performance of the fund (they get a larger share of the profits if the fund generates extraordinary results).

Scientific research (often labelled "agency theory") has shown that private individuals managing an enterprise - which in private equity is the individuals establishing the investment manager and initiating the fund - need to have an asymmetric upside investment return in order to have aligned interests with the large institutional investors that comprise the passive investors into the fund. Research shows that private individuals frequently are more worried about losses than institutional investors. Without such asymmetric upside, private individuals tend to manage the enterprise in a way that the passive investors would view as overly risk-adverse. This theory is frequently also applied to other situations, for example ship captains in the 18th century, or in modern day management teams in companies; the private individual who is asked to invest in the enterprise which he/she is managing, needs to have an asymmetric investment upside in order to manage the enterprise at a risk level that is desired by the passive institutional owners.