Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private Equity
ISB – PGPGPGP – Co22

Ramana Sonti

Indian School of Business

March 2022
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

1 Private equity

2 PE structure

3 LP-GP contracting
Payoffs
Other terms

4 PE returns
Performance metrics

5 PE and Finance
Investments
Risk and return

6 Recent trends in PE
Global
India
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Alternative investments

• Refers to generally any asset class, except for (long only) Equity and
Bonds
• Private equity
• Fund of funds
• Hedge funds
• Real estate
• Currencies
• Commodities
• Art...
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

What is private equity?

• Broadly refers to investment or ownership in private companies

• Typically, any privately-negotiated equity-type investment in a firm
• Encompasses:
• Venture capital
• Growth equity
• Buyouts
• Variations: Venture debt, Private investment in public equity
(PIPE)...
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity v. Public equity

Private Equity Public Equity

Non-public ownership Public ownership
Illiquid Liquid
Valuation harder Valuation easier
Small intermediaries Large intermediaries
Ownership-control closely tied Ownership-control separation
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Early capital: First stop

• Bootstrapping
• Retain full ownership
• Slow growth
• Credit Cards
• Easy to get, and getting easier
• Build credit history
• High interest rates
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Early capital - FFFs

• Friends, Family, and Fools

• Often interest-free loans...
• ...else equity (???)
• Limited amount of capital
• Can you come back for more?
• Mixing private and business
• What if you fail?
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Early capital - Investors as angels

• Private investors investing own wealth

• Motivation
• Money
• Mentoring
• Product/cause
• Expertise and reputation
• Prior business/entrepreneurial experience
• Prior investing experience
• Connections
• Finding angels requires extensive networking
• Different types of angels
• Individual angels
• Angel network
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity firms

• “Professional” investors
• Invest “others’ ” money
• Focused on limited set of industries
• Looking for big winners
• Often value-adding investors (more later)
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity: Types

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity: Stages

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity: Characteristics

• Most will not value assets daily

• Lock-up period required
• Limited in size to preserve returns
• High minimum investment
• High expected (risk-adjusted) returns
• Low correlation with traditional assets
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE microcosm
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE microcosm: Participants
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE fund lifecycle

Source: NVCA 2020 Yearbook

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Overlapping PE funds

• Successful PE firms typically have multiple active funds at any given

point in time, separated by investment period
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Who invests in PE funds?

Source: Sensoy et al, JFE(2014); No. of LPs, 1991-2006

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity: Generic structure

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity: Pure Indian

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity: US parent – Indian child

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity fund: Structure

• PE fund
• Investors in the fund
• Limited partners (LP)
• Commit to making capital contributions (capital commitment)
• Limited transferability of partnership interest
• Financial sponsor (“Sponsor”)
• PE investment firm
• Formed by principals as a management partnership or LLC to serve as the
fund’s General Partner (GP)
• Sponsor makes the investments for the fund
• Limited Partnership Agreement (LPA) defines LP-GP rights and
responsibilities
• General partners (GPs)
• Manage fund’s investment - identifying, evaluating, monitoring, exiting
• Sponsor operates under the guidance of the GPs
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private equity: Mechanics

• Entry can be at any stage

• Investors (LPs) commit to invest $X in the venture over 10 years, with possiblity of
extensions for upto 2 one-year periods
• Capital calls from PE fund manager (General Partner – GP) to be met when
requested (5 to 10 day notice)
• GPs also invest (GP commitment) along with the LPs in the limited partnership,
about 1.1%-5%
• LP has no control but also no liability (beyond what is invested by them)
• GP has control over company management, and also the liability
• Fees: During investment period – a percentage (usually 2%) of committed capital;
afterward, on invested capital
• Return gained from exit, at a liquidity event
• Typically GP gets to keep 20% of proceeds (“carry”)
• Initial public offering (IPO)
• Sale of the company to buyer
• Company buy back
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

GP compensation structure

• Management fees
• 1.5% - 3% of committed capital for VC fund; 1.5% - 2.5% for Buyout fund
• Carried interest (“Carry”)
• Share of fund’s profits, typically 20%
• Transaction fees
• From portfolio companies including investment banking fees, break-up fees,
monitoring fees, and consulting fees
• Often, LPs require that this be adjusted against management fees
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Management fees

• Could be about 1%-2% of capital

• Cover GP salaries and other fund operating costs
• Paid quarterly or semi-annually
• Rate may drop after the investment period (often by 10% per year)
• Basis may change - e.g., as % of
• Committed capital
• Contributed capital
• Net invested capital (net of exits)
• May be reduced...
• ...by fees GP receives from portfolio companies
• ...in exchange for greater carry
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Carried interest

• LP-GP relationship: a Principal-Agent problem

• Pay-for-performance through carried interest
• Threshold basis for calculating carry: some alternatives
• Cumulative profits (“conservative” or “back-loaded”)
• Differing incentives in good v. bad sequential outcomes
• Transaction by transaction (“aggressive” or “front-loaded”)
• Tends to be preferred by younger GPs
• LPs may require a preferential return (next slide)
• Clawback provision for LP protection - but messy since there is
seldom an escrow; less likely since the 2008 financial crisis
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Profit allocation: Some alternatives

• No Preferential Return to LPs - so a 20/80 split

• Preferential Return to LPs (“hurdle”, e.g., 8% IRR)
• Permanent
• 100% of net profits allocated only to LPs until LPs receive the specified hurdle
rate
• Additional profits split as though there was no preferential return, i.e., 20/80
• Thus, if there is a 7% return, GPs get no carry.
• If there is a 10% return, LPs get 8% first, and then GP gets 20% of the
remaining 2%
• Disappearing - in the above example of 10% return, after 8% is given to
LPs
• The remaining 2% excess goes to the GP until the GP “makes up” or “catches
up” to the 20/80 split
• Any additional profit is split with no preference
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Carry: Graphical

• See LP GP payoff.xlsx
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Profit allocation to LPs: Forms

• Cash
• Restricted securities
• Freely tradable securities - typically values as of the last reported
price on distribution day
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Restrictive covenants

• Given LP’s limited legal investment role, there are covenants related
to restrictions on
• Fund management
• E.g., size of an investment, use of debt, prevent coinvestment with
own earlier or later funds, reinvestment of fund profits
• GP activities
• Own investment in select firms, sale of GP interest to others (use
“vesting”), adding GPs, spending time on outside activities
(fundraising, etc.)
• Investment type
• Investing in public securities, new investment classes
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Fund advisory board

• Typically with 3-9 LPs appointed by GPs

• Little influence over investment decisions (would affect their limited
liability)
• LPs often have the right to
• Approve mark-ups and mark-downs in valuations of portfolio company
holdings
• Address conflicts of interests
• Approve extensions of the partnership life
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Alternative measurement metrics

• Metrics commonly used to report performance to LPs, mostly

quarterly
• Return
• Return multiples - Cash on cash return (i.e., Money Received/Money
Drawn)
• IRRs (net of carry paid to GPs)
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Flow of funds - Example

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Gross v. Net measures

• How did the Fund perform? Gross performance (before carry)

• Gross Return = (Proceeds-Investments)/Investments = (239.9-64)/64 =
274.8%
• Gross Return multiple = Proceeds/Investments = 239.9/64 = 3.75x
• For Gross IRR calculation, Cash flows = Proceeds – Investments
• How did the LP perform? Net performance (after carry)
• Net Return = (Distributions-Calls)/Calls = (207.8-79.5)/79.5 = 161.4%
• Net Return multiple = Distributions/Calls = 207.8/79.5 = 2.6x
• For Net IRR calculation, cash flows = Distributions - Calls
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Role of time and use of IRR

• Returns and Multiples in the previous example ignore the role of time in the
investment and distribution processes
• Assuming that the holding period on LPs’ investment were 10 years, the annualized
1
LP return would be = (1 + 1.614) 10 − 1= 10.08%
• Time plays an important role in PE
• Investments and distributions do not happen in one go
• Annualized returns put equal weight on each year.
• However, investments and distributions typically happen at different points in
time
• There may be multiple periods of investments and distributions, some
overlapping and some not
• Contractual terms determine the size and timing of distributions or carry. e.g.,
• Timing of carry depends on whether carry is taken transaction-by-transaction
or cumulatively
• Size of distribution would depend on whether LP has a preferential return or not
• IRR allows taking timing into account
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

IRR - A review

• The Internal rate of return (IRR): discount rate that makes the PV
of a cash flow stream equal to zero
• IRRs are generally considered the definitive performance measure
because they reflect both cash flow size and timing
• See Returns.xlsx
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

IRR: Example

• Assuming carry is paid after the cumulative threshold of the capital called
• Assume 20% carry, i.e., Carry = 20% × (Cumulative Proceeds - Cumulative Calls)

Year Fees Investment Capital Calls Proceeds Distribution Gross CF Net CF

=Proceeds-Carry =Proceeds-Investment =Distribution-Calls
0 -1.7 -10.0 -11.7 -10.0 -11.7
1 -1.7 -21.0 -22.7 -21.0 -22.7
2 -1.7 -13.0 -14.7 -13.0 -14.7
3 -1.7 -12.5 -14.2 5.1 5.1 -7.4 -9.1
4 -1.7 -4.0 -5.7 24.6 24.6 20.6 18.9
5 -1.6 -2.5 -4.1 -2.5 -4.1
6 -1.5 -1.5 9.1 9.1 9.1 7.6
7 -1.4 -1.0 -2.4 -1.0 -2.4
8 -1.3 -1.3 13.8 13.8 13.8 12.5
9 -1.2 -1.2 0.0 -1.2
10 0.0 187.3 155.22 187.3 155.2
Cumulative -64.0 -79.5 239.9 207.8 IRR IRR
21.7% 16.5%

• Gross Multiple = 239.9

64 = 3.75x
• Net Multiple = 207.8
79.5 = 2.61x
• Under more aggressive carry (i.e., deal-by-deal carry), the Net IRR would be lower.
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Alpha: Another performance metric

• Alpha = Actual return - Expected return (using CAPM)

• Captures the return above the “fair” (risk-adjusted) level
• Nice to have
• Hard to obtain
• Harder to measure

• CAPM?
• Illiquidity?
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Other considerations

• Unrealised returns - E.g., Kleiner Perkins

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Situating PE in the theory of finance

• PE sits right in the middle of corporate finance and investments

• Corporate finance:
• LP-GP issues, GP-company management issues
• Agency problems and contracting around them
• The role of incentives in fund management
• Investments:
• Risk v. return
• Idiosyncratic v. systematic risk
• Liquidity and asset pricing
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Takeaways from theory

• Investors would do well to diversify (to the point that there is only systematic
risk in the risky asset portfolio).
• The best risky asset portfolio is the market portfolio itself, a stock market index:
hence all investors should hold a broad stock index
• Risk aversion dictates each investor’s split between bonds and stocks; I may
choose a 60:40 split, you may choose a 30:70 split
• The equilibrium logic of the CAPM dictates that prices move in response to
information very quickly so that at each instant, the market portfolio is the best
risky portfolio
• Also, the CAPM says that beta matters and only beta matters for expected
returns; just stare at the following equation:
E (r ) = rf + β [E (rm ) − rf ]
• Market prices are always right: markets are efficient
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Private Equity: Risks

• Illiquidity:
• Capital commitment over long periods of time
• Secondary market not as active as public equity; discounts if need to exit

• Concentration:
• PE funds hold a portfolio of, typically, 5-15 companies
• Diversification low
• Idiosyncratic risk matters!

• The “J” curve:

• Returns tend to come in the latter part of the period
• Early period returns are often negative
• Calls for patience
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

The “J” curve

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

The “J” curve...contd

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Returns on private equity...1

Source: Global PE Report, 2020, Bain & Co

• PE has outperformed public markets but they have started to converge, especially in the US
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Returns on private equity...2

Source: Global PE Report, 2020, Bain & Co

• PE’s convergence with public equity in the US has been happening over the last decade
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Returns on private equity...3

Source: Global PE Report, 2020, Bain & Co

• Top PE firms continue to perform well, outperforming the rest by a wide margin
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

Macro contibution of PE

• Key source of finance for early-stage firms and firms that are
restructuring
• Drives growth
• Employment
• Incomes
• Source of value-added over public equity
• Superior governance
Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

India: An attractive destination in APAC

• Second largest no. of deals and highest growth in APAC region

Source: India PE Report, 2020, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: 2010-2019

Source: India PE Report, 2020, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: 2011-2020

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: 2019-20, without Jio

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: 2019-20, Jio

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: 2020 Top Deals

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: 2020 Deals by Industry

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: Consumer Tech...1

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: Consumer Tech...2

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: IT and ITeS

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: Health Care

Source: India PE Report, 2021, Bain & Co

Private equity PE structure LP-GP contracting PE returns PE and Finance Recent trends in PE

PE investments in India: Pandemic Effect

Source: India PE Report, 2021, Bain & Co