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Private Equity (PE), Venture Capital (VC) are terms you cannot escape in the 21st Century.
Thanks to the likes of Facebook and Uber, it seems this is the era where investments go mainstream and cross over into the forefront of one’s consciousness.
While everyone bandies technical jargon and buzzwords around, very few people know how PE actually works, and more importantly, how it makes everyone money.
We begin by splitting up the two main types of PE that seem to be as interchangeable as they are incomprehensible to the man on the street.
PE is equity that is not listed on any public exchange. It consists of investments made directly into private companies or buyouts of public companies that result in a delisting of public equity.
While they are both technically types of PE (both gather pools of investors and invest their collective pools of money into multiple businesses on behalf of those investors), VC and PE are ostensibly very different animals, with very different aims.
VC is very much at the birthing stage of businesses, taking a high risk, high reward approach to investing.
VC firms tend to get involved at early stages when the potential for business growth is at its greatest and (in Asia) tend to stick to a lot of smaller investments (anywhere between S$50k and S$2m). Essentially, they are spreading the risk by investing small sums in 10 start-up businesses as opposed to investing large sums in 2-3 businesses.
People who invest in VC funds tend to have a healthy risk appetite and are prepared to lose their money in order to double or triple it.
PE, on the other hand, tends to come into play at a later stage. These funds tend to invest more at the Series A rounds and beyond when the start-up has proved its concept and needs money to take it to the next level.
Their ticket size tends to be far higher (anywhere between S$500k to S$20m on average), the number of businesses they invest in much lower, and the level of due diligence into the investee company far more comprehensive.
How does a PE firm actually make money?
Investment fees: PE firms usually charge investors a fee for investing in a fund. This is typically between 1% and 2% of the invested amount per annum. It is essentially a fee to cover the time and expertise of the fund managers.
Management fees: PE firms often make money from the company being invested in too. In many deals they will take a small fixed percentage of the investment as a transaction fee. In some cases, the firm may also charge portfolio companies (the businesses they invested in) fees for consultations, advice and monitoring of their investment.
Exits: PE firms make returns on their successful investments – if a company is sold for a profit on the original sum put in, then the PE firm takes a cut of that profit.
Dividends: If a portfolio business is making healthy profits, then as a shareholder, the PE firm will be able to call in dividends on the profit. This tends to happen with later stage businesses only.
The way money is made on both of these methods is known as “Carried Interest”. Most PE firms negotiate to receive 20% of the carried interest on their investment profits. However, firms must achieve a predetermined rate of return (referred to as the hurdle rate) before taking their share. The hurdle rate is the rate of return they promise the investor on an investment and is usually set at around 8% to 12%.
The above will hopefully share the ways in which PE firms generate revenue and gather profits. Albeit a snapshot of the different revenue models employed by players in this finance sub-sector, it encompasses all the main ways in which a successful firm in the industry is run.