Fundamentals of Private Equity and Venture Capital - PEI Media

GETTING THE MOST OUT OF THIS MODULE
Welcome to Module 2 in the Fundamentals of private equity series. This module
focuses on private equity as an asset class. It is designed to work both as a stand
alone section and as part of the whole series. It necessarily draws upon topics
reviewed in Module 1, and seeks to avoid repetition of their content. However, for
the benefit of the stand alone reader, a comprehensive glossary has been incorporated,
which explains the background and use of private equity terminology.
All terms which may require explanation or expansion are printed in bold, to
indicate that there is a glossary entry for them.
Introduction
This module focuses on the private equity industry from the viewpoint of the
institutional investors – pension funds, endowment funds, insurance companies
and banks – who provide its raw material – capital.
The emphasis here, unlike other modules in this series, is on performance issues
not at the individual investment level but across funds, portfolios of funds and
the private equity industry as a whole. We are concerned with:
• How does private equity behave as an asset class – what are its characteristics
and how do they differ from quoted equities?
• Why do institutional investors allocate capital to private equity?
• What are the factors that drive the development of private equity markets?
Terminology
It is difficult to avoid confusion in the use of generic terms such as management,
investor and investment when discussing private equity at the fund level. The private
equity fund is the core part of the process. It raises money from investors
(who in turn are themselves managers of investment funds), and is managed by
a private equity firm, often referred to as a general partner, but also as a manager
or a management team. It then makes investments (hence becoming an
investor) in private companies which in turn have their own management teams.
We therefore need to be careful in our choice of terms for the various participants.
By institutional investors, investors or limited partners, we mean the
pension funds, insurance companies and the like who allocate capital to private
equity funds. By private equity firm, fund manager or general partner, we
mean the specialist teams who raise private equity funds and are responsible for
making and managing investments in individual companies.
Returns – and risk
The private equity industry consistently claims to
produce returns to its investors which exceed
those available from investing in conventional,
quoted equities. Before examining these (much
debated) claims in some detail, however, we
must appreciate that simply comparing annual
rates of return from the two different asset classes
is of limited value. This is because institutional
fund managers do not primarily focus on
absolute levels of return; they take into account
the risks associated with making a particular
investment. Risk, in this context, means the probability
of failing to achieve a targeted or desired
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THE FUNDAMENTALS OF PRIVATE EQUITY 5