Investor capital from limited partners drives the private equity industry. Obviously without capital, private equity firms wouldn’t have any money to invest. But how do private equity firms actually go about raising this capital? This section hopes to cover a high level overview of the basic ins and outs of how private equity firms raise capital from limited partners.
What is fundraising?
Fundraising is the process of an investing firm (e.g. private equity, venture capital, hedge funds, debt funds, etc.) getting money from investors (Limited Partners or LPs) in order to invest on the LPs behalf.
Overall, the easiest way for a private equity firm to convince investors to invest is to have strong historical performance. For this reason, new funds and private equity firms with little experience have a much more difficult time raising capital from investors.
How does it work?
Private equity firms, also called General Partners (GPs), raise capital from Limited Partners. Limited Partner is a common term used for many different types of investors, such as pension plans, university endowments, insurance companies, family offices, and high net worth individuals, who are investing in other funds for a stated period of time.
So why would LPs want somebody else handling their money? Because they have a lot of it and not enough expertise to invest across all different investing strategies that exist. For example, some pension funds manage upwards of $200B dollars. That’s a lot of money to invest. Instead of hiring thousands and thousands of investment professionals internally, LPs “outsource” a lot of their investing activity to many different funds who are experts in a given strategy (e.g. private equity, venture capital, hedge funds, debt funds, etc.).
In order to get money from LPs, private equity firms need to make a strong case for why they can manage that portion of money better than an LP. Firms will pitch their investment strategy, talk about historical investments, returns, and industry experience, all in hope to persuade LPs that the PE firm can make outsized returns for their investors.
How much money has been raised in the past?
Private equity fundraising is cyclical and is generally correlated with the economic environment – when the economy is strong, more funds are raised, and vice versa.
How much money is being raised today?
Private equity fundraising has surprisingly rebounded extremely well since the financial crisis. According to Bain and Company’s 2016 Global Private Equity Report, at the start of 2016, 12 large buyout funds raising $5bn or more are still looking to raise $86bn. This means the general partners are still starting funds at a rapid pace.
Investors have also maintained a large appetite for private equity returns. Bain and Company’s 2016 Global Private Equity Report cites that almost 90% of limited partners believe that private equity returns will exceed public market returns by more than 2%. This confidence in the assets class has caused many LPs to say that they planned to increase their PE commitments in the future.
What fund types are most popular?
Preqin’s 2016 Private Equity Industry Report analyzes global private equity by types of funds that are being raised the most. From 2010-2015, the following types of funds increased fundraising the most:
- Natural Resources: ~26% CAGR
- Mezzanine: ~21% CAGR
- Real Estate: ~17% CAGR
- Private Equity Buyouts: ~16% CAGR
- Venture Capital: ~13% CAGR
Why is it so hard to raise a first-time fund these days?
According to Preqin, on average, first-time funds tend to outperform established funds in just about every historical year. So why do first time funds have such a difficult time raising capital? Here are a couple of common reasons to consider:
It takes a lot of work. If LPs have an option to invest in an established fund that has performed well, why would they bother doing research on new unproven funds? One answer would be “to make a lot of money if the new team is successful.” But imagine if an LP passes on an opportunity to invest in an established fund in order to invest in a new fund, and then that new fund doesn’t perform well? This is a nightmare scenario for any fund manager on an LP side.
Investing in a new fund requires a lot of work, it has limited upside potential, and it comes with a lot of risk, both financial and reputational. This is why many LPs have internal policies in place that prevent them from even considering first-time funds.
It is difficult to identify successful managers.Investment professionals work in teams and deal teams often times change from deal to deal (based on people’s availability and expertise). So when one senior investment professional wants to leave his or her firm to start a new fund, it is difficult for him or her to claim / prove that they were the one who made the investments successful.
What do they do?
Placement agents help private equity firms raise money from investors. The role of a placement agent is to introduce the PE firm to potential investors and to help draft a compelling story for why LPs should invest in the firm.
Why do private equity firms need them?
Placement agents maintain relationships with a number of institutional investors and some agents target specific types of investors. Most private equity firms do not have the time or the resources to maintain relationships with potential investors, and placement agents are able to “vet” private equity firms to investors.
Additionally, placement agents help draft all necessary marketing and legal materials necessary for a successful fundraising process. This saves a lot of time for the PE firm’s investment professionals who can focus more of their time on finding and evaluating attractive investment opportunities.
How much do they get paid?
These placement agents usually collect a fee of 2 – 3% of the funds raised.
Private Placement Memorandum (PPM)
What is it?
A private placement memo is a marketing document used by placement agents and private equity firms to entice investors to give them their money. It essentially describes two broad themes in a lot of detail: (i) overview of the PE firm and its investment strategy, and (ii) the transaction details (e.g. how much money on what terms).
- Executive Summary
- Investment Highlights
- Summary of Key Terms and Conditions
- Market Opportunity
- Overview of the Fund
- Management Overview
- Track record
- Firm strategy
- Offer Terms
- Distribution plan
- Description of investments
- Use of proceeds
- Other regulatory items
Why is it important?
The private placement memorandum is the document that details most important information for a limited partner to make an investment decision. The details in the PPM are often highly negotiated between limited partners and general partners, and can often times be what makes or breaks an investment from a limited partner. Private equity firms must be detailed, direct, and precise in their PPM’s as well as be highly consistent with their message when they meet LPs in person.