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Private Equity: Glossary of Terms
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Private Investments: Glossary of Terms
Accredited Investor: See
Accredited Investor.
Angel investor: A person who provides backing to very early-stage
businesses or business concepts. Angel investors are typically
entrepreneurs who have become wealthy, often in technology-related
industries.
Board seats: Venture firms often acquire positions on the board
of directors of their portfolio companies. A board seat gives a venture
firm a means of monitoring and managing a company they invest in.
Bridge financing: As the name implies, bridge financing is
intended as temporary funding that eventually will be replaced with
permanent capital. In some cases, lenders will provide buyout firms and
venture capital firms with bridge loans so that they can begin
investing, before they have closed on capital for their funds. Likewise,
a buyout or venture firm might provide a portfolio company with
temporary financing until permanent financing is in place.
Capital take-down: The schedule by which the general partner of a
fund draws down capital from the limited partners to be used for
investments. Most general partners today call down capital only as they
require it, rather than in pre-set amounts according to a rigid
timetable.
Carried interest: The general partner’s share of the profits
generated through a private equity fund. The carried interest, rather
than the management fee, is designed to be the general partner’s chief
incentive to strong performance. A 20 percent carried interest – meaning
that the remaining 80 percent reverts to the limited partners – has been
the industry norm, although some firms now take 25 percent or even 30
percent, based on very strong performance on past funds.
Catch-up: This is a common term of the private equity partnership
agreement. Once the general partner provides its limited partners with
their preferred return, if any, it then typically enters a catch-up
period in which it receives the majority or all of the profits until the
agreed upon profit-split, as determined by the carried interest, is
reached.
Co-investor: Although used loosely to describe any two parties
that invest alongside each other in the same company, this term has a
special meaning in relation to limited partners in a fund. By having
co-investment rights, a limited partner in a fund can invest directly in
a company also backed by the fund managers itself. In this way, the
limited partner ends up with two separate stakes in the company; one,
indirectly, through the private equity fund to which the limited partner
has contributed; another, through its direct investment. Some private
equity firms offer co-investment rights to encourage limited partners to
invest in their funds.
Consolidation: Also called a leveraged rollup, this is an
investment strategy in which an LBO firm acquires a series of companies
in the same or complementary fields, with the goal of becoming a
dominant regional or nationwide player in that industry. In some cases,
a holding company will be created, into which the various acquisitions
will be folded. In other cases, an initial acquisitions may serve as the
platform through which the other acquisitions will be made.
Direct investment: See Co-investor
Distributions: Cash or stock returned to the limited partners
after the general partner has exited from an investment. Stock
distributions are sometimes referred to as “in-kind” distributions. The
partnership agreement governs the timing of distributions to the limited
partner, as well as how any profits are divided among the limited
partners and the general partner.
Due diligence: A process of inspection that a venture capital or
other private equity firm carries out before closing on a deal. Venture
capitalists, for example, might review a company’s accounting practices
and managerial structure.
Evergreen fund: A fund in which returns generated on investments
are automatically returned to the general pool, with the aim of keeping
a continuous supply of capital on hand for investments.
Exit: The means by which a private equity firm realizes a return
on its investment. For venture capitalists, this typically comes when a
portfolio company goes public, or when it merges with, or is acquired
by, another company.
Fund of funds: A private equity fund that, instead of being used
to make direct investments in companies, is distributed among a number
of other private equity fund managers, who in turn invest the capital
directly. Funds of funds often give individual limited partners access
to funds from which they would otherwise be excluded. Also, by spreading
the capital more widely, the risk to limited partners is reduced.
Fund raising: The process through which a firm solicits financial
commitments from limited partners for a private equity fund. Firms
typically set a target when they begin raising the fund, and ultimately
announce that the fund has closed at such-and-such amount, meaning that
no additional capital will be accepted. Sometimes, however, the firms
distinguish between interim closings (first closings, second closings,
etc.) and final closings. The term “cap” is used to describe the maximum
amount of capital a firm is willing to accept into its fund.
General partner: In addition to being used as a title for
top-ranking partners at a private equity firm, general partner (or
general partnership) is used to distinguish the firm managing the
private equity fund from the limited partners, the individual or
institutional investors who contribute to the fund.
General partner clawback: This is a common term of the private
equity partnership agreement. To the extent that the general partner
receives more than its fair share of profits, as determined by the
carried interest, the general partner clawback holds the individual
partners responsible for paying back the limited partners what they are
owed.
General partner contribution: The amount of capital that the fund
manager contributes to its own fund in the same way that a limited
partner does. This is an important way in which limited partners can
ensure that their interests are aligned with those of the general
partner. The U.S. Department of Treasury recently removed the legal
requirement of the general partner to contribute at least one percent of
fund capital. However, a one percent general partner contribution
remains common, particularly among venture capital funds.
Incubator: An entity designed to nurture business concepts or new
technologies to the point that they become attractive to venture
capitalists. An incubator typically provides both physical space and
some or all of the services – legal, managerial, technical – needed for
a business concept to be developed. Incubators often are backed by
venture firms, which use them to generate early-stage investment
opportunities.
Initial public offering (IPO): When a privately held company –
owned, for example, by its founders and its venture capital investors –
offers shares of its stock to the public.
Lead investor: The firm or individual that organizes a round of
financing, and usually contributes the largest amount of capital to the
deal.
Leveraged buyout (LBO): The acquisition of a company in which the
purchase is leveraged through loan financing, rather than being paid for
entirely with equity funding. The assets of the company being acquired
are put up as collateral to secure the loan.
Leveraged roll-up: See Consolidation.
Limited partners: Institutions or individuals who contribute
capital to a private equity fund. Limited partners typically are pension
funds, private foundations, and university endowments. However, private
equity firms themselves may serve as limited partners in other firms’
funds, as, for example, when a large buyout firm channels money to a
fund managed by a venture capital firm. See also General partner.
Limited partner clawback: This is a common term of the private
equity partnership agreement. It is intended to protect the general
partner against future claims, should the general partner or the limited
partnership become the subject of a lawsuit. Under this provision, a
fund’s limited partners commit to pay for any legal judgment imposed
upon the limited partnership or the general partner. Typically, this
clause includes limitations on the timing or amount of the judgment,
such as that it cannot exceed the limited partners’ committed capital to
the fund.
Management buyout: The acquisition of a company by its
management, often with the assistance of a private equity investor.
Management fee: This annual fee, typically a percentage of
limited partner commitments to the fund, is meant to cover the basic
costs of running and administering a fund. Management fees tend to run
in the 1.5 percent to 2.5 percent range, and often scale down in the
later years of a partnership to reflect the reduced work load of the
general partner. The management fee is not intended to be the primary
source of incentive compensation for the investment team. That is the
job of the carried interest.
Market capitalization: The overall value of a publicly traded
company, derived by multiplying the total number of shares by the share
price.
Mezzanine fund: Used to provide a middle layer of financing in
some leveraged buyouts, subordinated to the senior debt layer, but above
the equity layer. Mezzanine financing shares characteristics of both
debt and equity financing.
PIPEs: An acronym for “private investing in public equities.” See
Private placement.
Placement agent: An outside firm hired by a general partner to
market its fund to institutional investors. The general partner
typically pays a two percent fee of the capital raised from new sources
by the placement agent.
Portfolio company: A company in which a venture capital firm or
buyout firm invests. All of the companies currently backed by a private
equity firm can be spoken of as the firm’s portfolio.
Preferred return: The preferred return is a minimum annual
internal rate of return sometimes promised to the limited partners
before the general partner shares in profits. In effect, the preferred
return ensures that the general partner shares in the profits of the
partnership only to the extent that the investments perform well. Once
the preferred return is met, there is often a catch-up period in which
the general partner receives the majority or all of the profits until it
reaches the agreed upon profit-split, as determined by the carried
interest.
Preferred stock: This is one of the most common classes of shares
for venture capital and buyout firms to hold. Preferred stock pays
dividends at a set rate, and holders get paid before common stock
holders in the event of a liquidation. Convertible preferred stock is
convertible into common stock at a pre-determined price per share.
Private equity: Equity capital invested in private companies.
Typically, references to private equity encompasses both early stage
(venture) and later stage (buyouts) investing.
Private equity advisor: An outside firm hired by an institutional
investor, such as a state retirement system, to handle the selection,
negotiation and monitoring of private equity funds. An advisory
assignment can be non-discretionary, in which the institutional investor
retains the final say on investment decisions, or discretionary, in
which the advisor has the legal authority to make investment decisions
on the client’s behalf.
Private placement: This term is used specifically to denote a
private investment in a company that is publicly held. Private equity
firms that invest in publicly traded companies sometimes use the acronym
PIPEs to describe the activity – private investing in public equities.
Occasionally, private investors will acquire 100 percent of the shares
of a publicly traded company, a process known as a “going-private” deal.
Qualified Purchaser: See
Qualified Purchaser.
Seed-stage fund: A pool of money used to back companies too small
to attract mainstream venture firms.
Small Business Investment Company: A licensed member of a U.S.
Small Business Administration program that entitles an investment firm
to obtain matching federal loans for its private equity investments.
Typically, a firm will have access to $2 in credit for every $1 that it
invests in a company. If an SBIC raises $20 million, it will have access
to up to $40 million in low-interest loans, drawn down on a deal-by-deal
basis.
Spin out: A division or subsidiary of a company that becomes an
independent business. Typically, private equity investors will provide
the necessary capital to allow the division to “spin out” on its own;
the parent company may retain a minority stake.
Strategic investment: An investment that a corporation or
affiliated firm makes in a young company that offers to bring something
of value to the corporation itself. The aim may be to gain access to a
particular product or technology that the start-up company is
developing, or to support young companies that could become customers
for the corporation’s products. In venture capital rounds, strategic
investors typically are sometimes distinguished from financial investors
– venture capitalists and others who invest primarily with the aim of
generating a large return on their investment.
Venture capital rounds: Portfolio companies typically receive
several rounds of venture capital before going public. The first round
is usually smaller than subsequent rounds, and likely to involve fewer
investors. Note that first-round funding does not necessarily mean that
the company has received no previous outside backing. The term “first
round” is still appropriate if previous backing consisted of, say,
$500,000 from an angel investor. A first round typically is the first
round involving participation by a venture capital firm.
Warrant: An option to purchase stock in a company, typically
exercised over an extended period.
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