Private Equity Terminology
The finance world is riddled with lingo – and private equity is no exception. The private equity industry continues to grow from strength to strength, becoming one of the preferred funding strategies for public and private companies focused on value creation.
Most private equity funds have a 10-year life span and are illiquid, making early exits unlikely and returns unlikely for the first few years. High net-worth individuals and institutions are equally involved within the private equity space. Recent years have seen the industry become more accessible with accredited investors able to invest with minimums as low as £25,000.
Both newcomers and executives can find themselves navigating the tricky world of private equity terminology and jargon. At FD Capital, we work to support and mentor our talent pool of financial professionals, from private equity specialists to those taking their first steps into the industry. Join our talent pool today by submitting your CV to email@example.com.
Private Equity 101
Private Equity 101
Our private equity terminology guide breaks down the most common jargon within the industry. Some of these phrases are used solely within private equity, while others are used throughout the finance and investing industry.
General partners are an entity, usually in the form of a partnership. A general partner is the individual or individuals responsible for managing the private equity fund and its associated investments.
They earn a management fee that typically equates to 2% of the fund’s assets and have a share in its profits – known as carried interest. Although carried interest is usually set at 20%, this can range from 5% to 30% depending on the fund. A share of this carried interest may be passed on to individual asset managers.
The limited partners of a private equity fund are its clients. These clients are the investors who provide the capital for the fund and pay its management fees. Limited partners are protected from any loss beyond the capital they’ve invested. They’re also protected from legal action taken against the companies the fund has invested in and the fund itself.
A director or chairman of the company is a non-executive when they sit as a member of the board but are not an employee or in the executive management team. Non-executives are usually experts in their field and provide operational and strategic advice to the company’s C-suite and leadership team.
An anchor investor may also be known as a ‘cornerstone investor’. They’re the central investor in the private equity fund, usually making the largest capital commitment at an early stage in the fundraising cycle. This initial investment strengthens the fund’s standing and reputation, making it more likely to gain additional investment from other parties. Public investors are usually the anchor investor in venture capital funds.
Global Investment Performance Standards (GIPS)
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Global Investment Performance Standards (GIPS)
GIPS provide guidance for private equity firms. Since 2020, they have mandated the filing of a standardised disclosure by firms, including investment multiples and ratios to determine performance. Other information that must be declared includes the annualised and composite since-incept money-weighed returns on the fund’s portfolio.
Compensation Structures, Funding, and Equations
Venture capital is a form of equity usually focused on companies in their early development and start-up stages. By comparison, most private equity is targeted at more developed companies with an established market share.
Growth capital – alternatively known as ‘development capital’ – is a smaller investment that is used to fund business expansion for established companies. This capital can be utilised to develop products and services, explore acquisitions, and increase working capital.
Mezzanine is a finance type that utilises preferred equity or subordinated debt, typically seen as a more expensive alternative to senior or traditional secured debt. This type of finance is seen as being less likely to be repaid by the company in the event of a default and is subordinated by the company’s capital structure.
Carried interest is what makes up the majority of the compensation received by fund managers. This amount is calculated as a specific percentage of the fund’s profits. Typically, the carried interest is calculated at 20% over the threshold rate of return for the fund’s limited partners.
This form of compensation, unlike other income, is taxed as long-term capital gain. Therefore, it is taxed at a lower rate than the top-level income tax bracket. General partners find this option attractive as a result. However, only carried interest earned from fund investments held for three years or more can be taxed at this rate.
Distributed to Paid-In Capital (DPI)
Distributed to Paid-In Capital (DPI), alternatively known as ‘realisation multiple’, is calculated by dividing the cumulative distributions by paid-in capital. Potential investors use the DPI multiple to determine how much of the fund’s return has been paid out to investors – or ‘realised’.
Preferred Return, Clawback
Private equity has several compensation structures that specify a hurdle rate and clawback. A hurdle rate – alternatively known as the ‘preferred return’ – sets the minimum annual rate of return that limited partners must earn for the general partner to be entitled to earn carried interest from the fund’s profits.
The preferred return for most private equity funds is 8%. This hurdle rate also has a ‘clawback’ provision, enabling limited partners to recover a part of the carried interest from the general partner if future losses are lower than the preferred return.
Committed Capital, Vintages, and Drawdowns
The funding provided by limited partners is known as ‘committed capital’. This capital is not usually transferred to the company immediately as it is provided and invested over an identified period.
A ‘drawdown’ is when the capital is called forth by the general partner when they either require a portion of the committed capital to pay for the investment or if they’ve identified a new investment. Drawdowns are also known as ‘capital calls’.
Cumulative distributions are the total returns paid out to limited partners by the fund. Potential private equity investors will assess a fund’s cumulative distribution, including the amount and timing of these returns, before deciding to invest.
Residual value is the market value of the fund’s remaining equity. The fund’s net asset value (NAV) is often referred to as ‘residual value’ as it represents the value of all remaining potential investments within the portfolio.
Investors will compare residual value with the investment’s purchase price with the difference representing loss or unrealised profit.
Residual value is also defined as the value of non-exited investments that the fund is still actively involved with. Private equity funds typically report the residual value of the fund every quarter.
Sweet Equity – often known as ‘sweat equity’ – is a financial instrument that acts as a non-monetary equity for the time and effort employees put into a company, usually at its start-up stage. You can use the term ‘sweat equity’ to consider how it represents the work the employee puts into the company that is valued above the (usually lower) salary they receive.
Operations and Exit Strategies
Due diligence is the process of assessing different parts and functions of a business before making an investment or engaging with a company. Potential investors will undertake due diligence before deciding to invest in a private equity fund. Due diligence includes the company’s commercial, legal, management, financial, IT, and insurance operations.
An exit strategy is a plan to maximise the return for investors and the management team when the funding agreement comes to an end. These strategies are usually influenced by factors like industry trends and the current investment climate.
Popular exit strategies for private equity include initial public offerings (IPOs), secondary buyouts, and trade sales.
Management Buyout (MBO)
The management team of a company can lead on the acquisition of a company, usually in partnership with a private equity firm that invests alongside them. MBOs are seen as a lower-risk investment as the company’s management team remains in place.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the annualised implied discount rate that is calculated using cash flow. It’s a performance metric used for private equity funds as portfolio investments can be bought and sold several times over resulting in different capital contributions and distributions. The IRR factors all this in.
It is incorrect to compare the interest rates offered on a traditional bank account as the interest rate calculations are different. IRR calculations consider the cash tied up in the investment and only for the duration that it was tied up in the investment. Therefore, the IRR method typically produces a higher return than comparable calculations. Investors should avoid utilising IRR numbers to compare the returns of different investments.
Multiple on Invested Capital (MOIC)
Multiple on Invested Capital (MOIC) is a metric to assess the performance of an investment relative to the initial investment cost. For example, if a private equity fund invested one million pounds with a return of 10 million, the MOIC is 10x. However, the MOIC does not account for the duration of the investment, so it will remain the same whether the 10 million return was realised in 3 years or 10 years.
Residual Value to Paid-In Capital (RVPI)
Residual Value to Paid-In Capital (RVPI) is a metric that assesses the current market value of unrealised investments as a percentage of the called capital. This capital is the financing that has already been called in by the general partner.
The RVPI can be calculated using the residual value of the fund’s holdings and dividing it by the cash flows being paid into the fund. The cash flows will show the capital investment, fees paid, and any other expenses from the limited partners. Investors can utilise the RVPI and Investment Multiple to determine how much of the fund’s return is unrealised and dependent on the market value of the investment.
Limited partners prefer a higher RVPI ratio as it compares the remaining value of the fund to the up-front capital costs paid for by the investors.
Alternative Investment Fund (AIF)
An alternative investment fund (known as an AIF) is an investment fund that raises capital from several investors. This capital is invested in line with an investment policy that is pre-determined for the benefit of the investors. An AIF is not an Undertaking of Collective Investments in Transferable Securities (UCITS) or an operative company in an industry outside the financial sector.
Private Equity Ratios
Private equity funds that abide by the Global Investment Performance Standards (GIPS) will use the below ratios when presenting reports on their fund’s performance to potential investors. These ratios are used throughout the private equity industry.
Investment multiple is a ratio referred to as total value to paid-in multiple. This ratio can be calculated by dividing the cumulative distributions and residual value of the fund by the capital paid in by investors. The investment multiple offers insight into the performance of the fund by providing the aggregate returns as a multiple of the cost incurred by investors.
However, an investment multiple does not reflect the time value of money as it doesn’t consider when the returns are distributed to shareholders.
Realisation multiple – also known as the distributions to paid-in multiple (DPI). This multiple is calculated by dividing the fund’s cumulative distributions by the capital paid into the investment. It offers potential investors an insight into how much of the fund’s return has been paid out to investors or ‘realised’.
The realisation multiple should be considered with the investment multiple to give a full-picture look.
The PIC multiple is determined by dividing the paid-in capital by the capital committed by investors. This ratio allows potential investors to see the percentage of committed capital that has been drawn down by the general partner.
Potential private equity investors will also use the fund’s internal rate of return (IRR) to decide whether they should invest. They can also use the SI-IRR, which showcases the internal rate of return for the fund since the first investment was made
What is a Private Equity CFO?
Private Equity FD and CFO Recruitment
FD Capital is the UK’s leading financial recruitment agency, connecting start-ups and SMEs with FDs and CFOs who have experience working within the private equity industry. Our talent pool includes senior financial executives available to work on a part-time, full-time, and interim basis in-house and remotely.
Start the process of recruiting a private equity CFO or FD today by contacting our team at firstname.lastname@example.org or 020 3287 9501.
Importance of a Private Equity CFO
FD Capital is the UK’s leading specialist financial recruitment agency. We take a curated approach to recruitment, identifying the individual needs of our clients to find the right candidate the first time around. Our traditional recruitment and headhunting services provide 360-degree recruiting. Start recruiting your private equity CFO by contacting us at email@example.com or by calling us at 020 3287 9501 for a no-obligation consultation.
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