Private Equity Terminology – Understanding the Basics
Many of my clients aspire to be hired by a private equity firm and primarily for an executive role or independent directorship in one of the firm’s portfolio companies. More so than the deal side, there is increasing interest in the role of operating partner. In some initial discussions, I realize that although aspiring, some executives to do not understand the basics of private equity terminology or the difference between private equity, growth equity, venture capital or hedge funds.
I spend a lot of time, on the behalf of our clients, seeking opportunities within portfolio companies of private equity middle market growth as well as growth equity. Private equity is not to be confused with hedge funds or venture capital. Private equity is typically capital raised from private sources and utilized by private equity firms to provide growth capital or liquidity to owners, as well as leveraged buyouts. Sometimes it can be a combination of all three. Following is a glimpse into private equity terminology that is helpful to those aspiring to enter in the world of private equity —
Limited Partner (LP) vs. General Partner (GP)
Simply said, the private equity firm is the “general partner” (GP). The “limited partner” (LP) includes pension funds, college endowments, insurance companies or other private investors. The LPs invest millions of dollars into a fund with the private equity firm (GP) with the goal that the investments the GP makes for that fund increases in value over one to ten years. In return, the LP earns a return on their investment, known as IRR (internal rate of return). The particular fund encompasses an average of twelve companies.
Internal Rate of Return (IRR)
Highly important to the LP, IRR is a metric used to measure how well an individual investment has performed as well as how the private equity fund (GP) has performed. A good IRR for a fund is 15 to 20% and great is defined at 20% or more.
Assets Under Management (AUM) vs. Fund Size
There is a distinction between AUM and recent fund size. AUM is the total amount of capital that the private equity firm has raised over the life of the firm (GP). Private equity firms that have been in the business longer may be on their second, third or fourth fund. The most recent fund is what the GP has raised and is investing out of.
Carried Interest
Also known as “carry”, carried interest is the capital that is returned to the LP that is in excess of the LP’s original investment. It is a share of any profits that the GP receives as compensation. This compensation method also seeks to motivate the GP to work toward improving the fund’s performance. Typically, the amount for carry is 20 to 25% of the fund’s annual profit. Carry is intended to serve as the primary source of income for the GP. However, the GP must ensure that all of the initial capital that the LP’s contributed is returned along with a previously agreed rate of return.
2 and 20
Historically, 2 and 20 is how private equity firms (GP) are compensated for doing what they do. The GP earns a 2% annual management fee for all assets under management (AUM) in addition to 20% of the carry, which I overviewed above. In Summit Executive Resources’ most recent Private Equity in Transition Guide, I discuss the tremendous scrutiny that this fee arrangement has come under by the SEC.
Check Size, EBITDA & Multiple
The “check size” refers to the amount of capital (equity) the GP typically puts into their deals. This is also a good indicator of the size of the GP’s portfolio companies. EBITDA, Earnings Before Interest Taxes Depreciation and Amortization, is of highly significant importance to the GP. The GP typically tends to not discuss how small or large their portfolio companies are in terms of sales or revenues. They do more so talk in terms of “EBITDA” or “Enterprise Value” and in terms of ranges. A “multiple” describes the number driven mostly by the portfolio company’s industry, the quality of the company and how buyers regard a company. “EBITDA” multiplied by the “multiple” equates to the “enterprise value” of the company.
The Exit
The “exit” is what every GP must do with all of the investments they make – they must “exit” them and realize a return (for the LP and the GP). The exit can manifest in several ways such as selling to a “strategic”, to another private equity firm, or through IPO, or unfortunately through bankruptcy. A “strategic” is a buyer that is not another financial company (private equity firm, hedge fund, etc.), but is another company.
Other Resources
In addition to the private equity terminology shared above, I also recommend the following resources –
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