Private Equity

A private equity fund is a closed-end vehicle with a finite life, commonly ten years with provision for extensions. Investors do not hand over cash at inception; they sign a commitment, and the general partner draws that capital down through capital calls as deals are signed, typically over an investment period of roughly the first five years. The remainder of the life is spent managing and exiting holdings, with proceeds distributed as they are realised rather than reinvested.

This structure produces the J-curve. Early years combine fees and drawdowns with holdings still carried near cost, so reported returns are negative. Only as portfolio companies are written up and exited does the cumulative return turn positive. A candidate should read a poor two-year number on a young fund as a structural feature, not evidence of a failed strategy, and should recognise that committed but uncalled capital creates a liquidity obligation for the investor.

The asset class spans very different risk profiles. Venture capital funds minority or controlling stakes in early-stage companies with no earnings and often no revenue, accepting that most positions fail and returns depend on a small number of extreme outcomes. Growth equity funds established, expanding businesses with modest or no leverage. Buyouts acquire control of mature, cash-generative companies, financing a large share of the purchase price with debt serviced by the target's own cash flow.

Buyout returns decompose into three drivers. Operational improvement raises EBITDA through margin expansion, add-on acquisitions or repositioning. Multiple expansion sells the business at a higher valuation multiple than was paid, which depends heavily on market conditions and on entry discipline. Deleveraging transfers value to equity as debt is repaid out of cash flow. Sponsors emphasise the first; the historical record shows the second and third have contributed materially, which is precisely why vintage year matters.

Compensation has two layers. A management fee, commonly in the region of one to two percent, is charged on committed capital during the investment period and often on invested or net invested capital thereafter. Carried interest gives the general partner a share of profits, conventionally twenty percent, usually payable only after limited partners receive a preferred return, or hurdle, on drawn capital.

The mechanics of the waterfall determine who bears timing risk. Under a whole-of-fund, or European, waterfall, carry is paid only once the entire fund clears its hurdle, so limited partners receive their capital and preferred return first. Under a deal-by-deal, or American, waterfall the general partner is paid on individual successful exits, which accelerates carry and makes a clawback provision essential to recover overpayments if later deals disappoint. Catch-up provisions govern how quickly the general partner reaches its full profit share once the hurdle is met.

Because the general partner controls the timing of cash flows, time-weighted returns are inappropriate. Private equity is judged on money-weighted internal rate of return computed from drawdowns, distributions and the ending net asset value, supported by multiples: total value to paid-in capital, distributed to paid-in capital for realised cash returned, and residual value to paid-in capital for what remains unrealised. Reported figures are gross or net of fees, and the distinction changes the picture materially.

Interim IRRs rest on the general partner's own marks on unlisted holdings, so they are estimates rather than prices. A candidate should be able to compute a net IRR and the standard multiples from a cash-flow schedule, explain why a fund with a high IRR but low DPI has not yet proved anything, and interpret public market equivalent analysis, which asks whether the same cash flows invested in a listed index would have done better.