Hedge funds and Private Equity - PES

What is a fund of funds?
The fund of funds is a structure for sharing investment across several private equity funds. The
fund of funds is managed by a team of professionals offering investors the strategic construction
of a diversified portfolio and the selection of management companies. These professionals
manage the relationships with the various underlying funds, organize the review of valuations,
transfer information and provide back office services for the funds.
2.4 How they get the money
How do LBOs organise the money for their activities? Equity financing for all the types of
funds, including venture capital funds, typically involves the following steps:
Launching a fund:
First, a private equity company generally launches several independent funds in which
investors’ capital is combined. The typical legal form of funds in Germany is a GmbH & Co.
KG; in the UK and the United States they are limited partnerships. The investors do not take
any management decisions themselves; the operational aspects of the business are
combined in a separate company, frequently in the form of a general partnership. This
company, in turn, is frequently controlled by a (fund) parent company of the private equity
company, which performs a role comparable to that of a holding company. The advantage of
having a fund with the legal form of a GmbH & Co. KG is that the liability of its capital
providers (limited partners) is limited to the level of their capital contribution. This means that
individual investors are not additionally liable for losses through their private assets.
Acquisition of an investment in a business or purchase of a business division:
In the second step the fund acquires the target business. Then they would typically use a
blend of equity and borrowed capital to finance the purchase price, frequently at a ratio of
30% equity to 70% borrowed capital.
Restructuring, merging or splitting the acquired business:
For some – typically venture funds – the aim here is to increase the value of the business by
improving efficiency and productivity. But it can also mean that the sale of assets is made to
provide cash to be paid out. Operating costs, e.g. through job cuts, are reduced mainly to
increase cash flow. Cash flow may be used to borrow more debt in order to have cash for
payments to the PE fund.
Exiting the private equity company:
In the final phase the investor attempts to sell his investment at a profit. The LBOs frequently
do this via an IPO. It is now also common practice to sell to another investor (a so-called
secondary buyout).
2.5 Private equity is big and growing fast
At worldwide level, the US market is still by far the most mature and developed and accounts
for approximately 75% of the funds raised globally in the period 1983-2005 (€990bn).
However, Europe accounts for a large part of the remaining private equity transactions. European
funds in the same period (1983-2005) raised €350bn. 55% of the global total (€550bn)
has been raised in the last 5 years, with Europe seeing a new surge in fundraising in 2005
(€72bn) following a slow fundraising period from 2002 to 2004 (see chart below). The fundraising
i.e. the investor contributions to the PE-funds must, of course, also be seen in relation to
the real economy, the general macro-economic environment, the saving / consumption ratio etc.
Part I – Hedge funds and private equity funds – how they work
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