The Size of the Market

Private equity funds have been capturing the attention of investors and the press in the past few years for a number of reasons. Their performance has typically outstripped the equity markets and other alternative investment strategies. The deals pulled off by the private equity houses have grabbed headlines all over the world. In many cases, the LBO Funds have pooled resources in what have become known as "club deals" to acquire multi-billion dollar companies using leverage to fund the bulk of the purchase price. Companies such as Toys R Us, Hertz, Sears, Burger King and Tommy Hilfiger have recently been taken private by the Private Equity LBO funds. Not only have the deal sizes got bigger in recent years but the Funds formed have also got bigger in size. Now it is not uncommon for private equity funds to close on day of launch with $5-10 bn at their disposal.

According to Citigroup, the funds raised by US private equity funds in 2005 ($140 bn) exceeded new investment in stock mutual funds ($136bn). $167bn was raised through initial public offerings in comparison to $396bn spent by PE Firms on buy outs globally. The statistics available for this year both on fund raising and buy outs signal that 2006 may trump last year.

What is a Private Equity Fund?

Taking a step back, what is private equity and how are private equity funds structured?

Private equity is securities, typically stocks and shares issued by private companies. Funds that are formed to invest primarily in private equity may invest in private securities and/or private companies that are in one or more of the life cycle stages described below:

Venture Capital


Early development stage

Growth Capital


Expansion phase

Turnaround/reorganisation capital


Period of financial stress

Leveraged buyouts or recapitalisations


Later stage of development

Private equity funds may focus on one or more of these phases of investments and leveraged buyouts by these Funds of publicly traded stocks are becoming more common.


Although companies are sometimes used, the most common structure used for private equity funds ("Fund") is an exempted limited partnership, typically either domiciled in Cayman or in Delaware. The domicile of the Fund will largely depend on the nationality of the investors (and their tax status) and the global strategy of the Fund. For example, if the Fund expects to do most of its deals outside the US then the investment manager will probably set up the Fund in Cayman or another offshore jurisdiction which is most tax efficient for the Fund's investment strategy. This will avoid forming multiple alternative investment vehicles for non-U.S. deals. On the other hand, if the investors are US domiciled and/or the majority of investments will be in the U.S., the Fund may be formed as a Delaware Limited Partnership. Alternative investment vehicles known as "AIVs" are then formed as and when required for the purpose of structuring non-U.S. deals. The investors will invest in the AIV rather than the Fund for the purpose of that particular deal. AIVs are often formed in the Cayman Islands because it is tax neutral in terms of the return of capital contributions and profits to investors and the Cayman Islands exempted limited partnership model can be tailored to mirror the terms of the main Fund.

Commercial Terms

The commercial terms of each Fund vary but follow a standard model of a term of 5-7 years with the option of the General Partner of the Partnership to extend the life of the Fund by 1 or 2 years for the purpose of disposing of the portfolio positions and returning the capital to its investors (the Limited Partners). The Limited Partners take no part in the conduct of the business of the Fund and have no right to withdraw from the Fund prior to the expiry of the term of the Fund. Consequently, they are also known as "closed ended" funds for that reason. The Cayman Funds do not register with the Cayman Islands Monetary Authority as mutual funds under the Mutual Funds Law (Revised) of the Cayman Islands because they are closed ended. Typically the investment manager, the entity that controls the general partner of the Fund, is not regulated by the Cayman Islands Monetary Authority or the SEC in the U.S. Each investor undertakes to contribute capital up to a certain amount over the first 3 – 5 years of the Fund, as requested by the General Partner. The capital commitment is then drawn down as and when required to fund portfolio acquisitions and pay the expenses of the Fund. The General Partner is paid a Management Fee (of approximately 2% of the aggregate capital commitment) and a performance allocation (or carried interest) based on the profits generated. The terms of the performance allocation vary but can be up to 30% of the profits determined in accordance with the "waterfall provisions" of the Partnership Agreement. The minimum capital commitment required by an investor varies from fund to fund but is usually not less than $5m in the case of LBO Funds.

Investment Strategies

The investment strategies of the Funds vary. Many target certain geographical areas such as Japan, Far East, India, Europe and/or are specific to industry sectors. Other Funds are non specific and source deals wherever they can find value. Funds may also focus on one or more of the cycle stages of investment referred to above. Ultimately the strategy is relatively simple (in theory). Buy cheap, improve or add value by introducing new management or growing the business by strategic purchases that augment the company acquired and ultimately sell in 3-5 years either as a private sale or an IPO for a profit. Only at this time is the profit released to investors after repayment of the debt used to fund the acquisition.

Because there are start up costs in setting up the Fund and then additional draw downs of capital to fund acquisitions, the performance of the Fund will be negative over the first few years of the Fund until returns are made on the disposal of the acquisitions made. The graph below shows the typical performance cycle of a successful private equity fund and is known as the "J Curve".

As you can see from the "J Curve" above, the value of the private equity fund falls below the amount of capital that has been invested. During the initial years of the Fund's life cycle investments are held at cost and no dispositions will have been made to generate capital proceeds. The initial organisational costs must be absorbed and the management fees (based on the total capital commitment – not capital drawn down) and investment expenses are paid out of investors' capital.

Over the past number of years the top private equity firms have outperformed public equities, the majority of hedge funds and other alternative strategies. Debt has been relatively cheap and easy to procure from the lending institutions making the mega deals referred to above possible. Despite rumblings that interest rates may go up in the next few years there appears to be no slow down in the deal flow or formation of new funds. Indeed the typical life cycle for private equity funds was historically 5 – 7 years. The private equity firms are precluded by the terms of the Funds from setting up successor funds until approximately 70% of the capital commitments have been drawn down. In the past, it took about 5 years before this capital had been drawn down and a successor fund could be launched by the investment manager. Now the funds are drawing down this capital in as short a time as 18 months. This is a clear indicator of the increase in deal activity fuelled by this sector. Private equity funds are also taking advantage of the extra demand from investors and launching much bigger successor funds in the range of $5bn - $12bn per fund.

Opportunities for the Banks and Your Investors – Fund of Funds Strategy

To date, primary private equity funds have not been available to the man on the street. With minimum capital investments of $5m or more these vehicles are used by high net worth individuals, institutions and pension funds. The pension funds and the institutions are able to contribute sizeable allocations to the top private equity firms and have become increasingly sophisticated in negotiating the terms of the Fund to the benefit of all investors coming in to the Fund.

The opportunity for the banks that are not themselves forming their own private equity funds would appear to be in creating funds with the strategy of investing in these private equity funds. Known as a "fund of funds strategy", the Fund collects assets of its investors in a fund vehicle and invests through that fund in various private equity funds. The advantages to the investors are that they get access to funds that they would not otherwise be able to participate in and they get a diversification of risk with respect to the investments in the various private equity firms in which the Fund invests. These Funds often get access to private equity funds either as initial investors or by buying the Limited Partner interests in the secondary market. The secondary market has developed because the interests are not listed on any stock exchange and are not transferable without the consent of the General Partner of the Fund. Therefore opportunities arise to acquire these illiquid interests from Limited Partners who are not able to meet the drawdown of the capital commitment and risk forfeiting their investment unless they can sell their interest to another investor willing to assume the remaining balance of the capital commitment. Many Funds focused on this secondary market are able to value the underlying portfolios in the private equity fund and capture value by buying the interests at a significant discount to book value anticipating the upside on disposal of the underlying portfolios on the expiry of the Fund.

A number of the banks have set up fund of funds platforms in this manner to maximise the capital streams of their client base who wish to participate in the private equity funds formed for primary strategies. The terms of the fund of funds typically mirror the private equity funds although the minimum capital investment may be lower. The investors are locked in for the life of the fund and will receive distributions as and when the fund receives distributions from the underlying private equity funds. These funds can be set up relatively easily in the Cayman Islands. Attached as Appendix A is an example of a term sheet for a Private Equity Fund of Funds and the core investment strategies displayed by them.

Private equity fund of funds are offered by banks and other institutions as a platform of funds comprising various fund offerings with tailored terms for its retail and institutional clients. It is not uncommon for the platform to include a fund for "retail" clients offering lower minimum capital commitments and a separate fund for the institutional clients offering higher capital commitments for lower management and placement fees.

Finally, one new and innovative opportunity which is still to be scrutinised by the market is the latest offering by Kohlberg Kravis Robert & Co ("KKR"). At the time of writing this paper, KKR is in the process of marketing an investment fund to be listed on the Amsterdam Stock Exchange which would invest in portfolio acquisitions on a side by side basis with other KKR Funds. There is speculation in the Press that the IPO may raise as much as $5 bn for the fund. This type of fund or company may be attractive to some investors as there will be no long term capital commitment which is called upon over the term of the fund. Instead, the investor will simply buy and hold shares in a company just like any listed security. The shareholder will also be able to sell the shares more easily in the market place at less than the usual discounts seen for sales of partnership interests in the secondary market. The securities could also be used more freely by the shareholder as collateral for borrowings whereas partnership interests in private equity funds cannot be used as collateral without the consent of the General Partner. It remains to be seen whether this type of model will be copied by other institutions such as banks to raise capital for private equity or other alternative investment strategies.


Example of a Term Sheet for a Private Equity Fund of Funds

Please note that this is only an example of the terms – which will vary from fund to fund

Minimum Capital Commitment

To be drawn down over time based upon investment needs of the Fund: $250,000

Investment Period

3 – 5 years

Term of Fund

Not more than 1 year after last disposal of the Fund

Investor Qualifications

Depends on U.S. regulatory issues/domicile of investor etc.

Investment Strategy

Strategy is partnership investing and direct co-investments which can be split into 3 categories:


Primary Funds

  • U.S. and Non-U.S.
  • Historically Top Performing Funds
  • Diversification via:

- Size

- Industry

- Geography

- Stage


Secondary Funds

  • Strategic/Distressed Sellers
  • Possible discount to Net Asset Value
  • Quick Cash Returns
  • Mature Funds
  • Funds that are no longer blind pools

Direct Investments

  • Diversification
  • Market Leaders
  • Proven Management Teams
  • Strong Investor Syndicates

Annual Management Fee

Typically between 1% - 2%. This may be tapered based on the amount of capital commitment, e.g. 1.5% for commitments of US$1m or less and 1.25% for commitments of more than US$1m

Note: the underlying funds will be charging a management fee to this Fund on its capital investment so there are multiple fees at various levels

Investors Preferred Return

7% per annum compounded annually

General Partner's Profit

6% on distributions from Primary Funds

Share Percentage ("Carried Interest")

12% on distributions from Secondary Funds

25% on distributions from Direct Investments

Placement Fees

Capital Commitment

Less than $500,000

$500,000 - $1,000,000

$1000,000 plus

Placement Fee Rate





Paid by the Fund out of capital commitments

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.