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By M. Isi Eromosele
The legal vehicle for investing in private companies is
usually a “limited partnership.” The general partner (the investment manager) manages
the enterprise and the limited partners (the investors) own interests in the
partnership, which holds the portfolio companies, analogous to shares that are
proportional to their investment.
A typical private capital limited partnership has a 10- to 12-year
life. When the partnership is being formed, limited partners agree in advance
to commit a defined amount of capital to the partnership.
The committed dollars are not invested all at once, but are
drawn down, or “called,” by the manager over roughly the first half of the
partnership’s life as the manager discovers, cultivates, negotiates and
ultimately invests capital into private companies.
During the second half of the partnership’s life, capital is
returned to the limited partners in the form of distributions. These most often
result from a manager’s decision to exit an investment, usually through either
an initial public offering (IPO) or by selling the investment to a larger
company, often referred to as a “strategic buyer,” or another private capital
firm, often referred to as a “financial buyer.”
Distributions to investors can also result from a
recapitalization of and subsequent dividend by a portfolio company. Distributions
can be in cash or stock, referred to as “in-kind” distributions, reflecting an
investor’s pro rata share of a particular company’s stock.
The commitment stage of a partnership may vary in duration
and pace, depending on the availability of attractive investment opportunities.
In the same way, the distribution phase may vary according to the viability of
the exit markets (for example, the quality of the IPO and mergers and
acquisitions markets).
Secondaries
Investors may also look to gain exposure to the private
equity markets by purchasing existing interests in funds raised during prior
vintage years and therefore different investment cycles. This practice is
called “secondary investing” and is the way in which investors buy an interest
in a previously raised fund.
Secondary interests come about when an investor wishes to
sell or exit all or a portion of their fund commitment prior to the normal
liquidation period of the fund.
This practice enables prospective buyers to acquire funds
with greater visibility of the underlying portfolio companies that have been
purchased to date, sometimes at handsome discounts from their current net asset
value (NAV ). Secondary interests can also
help to moderate the “J-curve” in the early period of the investment cycle, since
the underlying assets are typically more mature and closer to realization. Secondaries
are a natural complement to a primary investing effort.
Co-Investments
A co-investment is a direct equity investment in a company
by a limited partner alongside a private capital manager (or general partner). Limited
partners typically engage in co-investments in situations where they believe
they have a preferred relationship with a general partner and access to the
general partner’s full set of information about the company, its management
team and prospects.
The risk associated with co-investments is that of greater
concentration in one particular company in contrast to a partnership investment
where limited partners get broad exposure to multiple portfolio companies.
The primary benefits for limited partners include an
opportunity to invest more capital with talented managers and, in many cases, to
invest parri passu with the general partner often without the cost of paying
either management fees or a carried interest charge. Co-investment programs can
complement fund investment programs but do require a different set of resources
and skills from partnership investing.
Risk of Loss
In spite of the potential for high returns from private
capital investments, venture capital investors in particular should be prepared
for partial or total losses on a significant number of the underlying companies
in their portfolio.
This is because any single start-up or early-stage
investment carries a material risk that it may not develop into a sustainable
business. Loss ratios in other private capital strategies are considerably
lower, primarily because investments are made in more seasoned companies that
are generally cash-flow positive and further along in their development.
Outside the U.S. ,
returns from developed economies are anticipated to be similar to those in the U.S. ,
while returns from emerging markets can be more volatile. Risk factors, including
the political and economic environment and, in some cases, the relatively
nascent infrastructure for private capital investing, need to be considered.
The Importance of Diversiļ¬cation
Attractive private capital results are earned when returns
on winners in a diversified portfolio amount to multiples of the amount invested,
while losses are limited to the amount invested. For this reason, it is
important not only that a manager diversify their investments within a
partnership portfolio, but that an investor also diversify their private
capital portfolio by type of investment strategy and vintage year.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control ©
2012 Oseme Group
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