How does a private equity fund work?

Funds of Funds Experts
Lower Mid-Market Experts

Stages in the life of a private equity fund

The life of a fund of funds is usually a bit longer than the life of a direct private equity fund (around 10 years). However, the investment rate of Qualitas Equity Funds allows this time to be reduced considerably, making it comparable to the duration of a direct private equity fund.

Investment commitment

Funds of funds operate through investment commitments. These commitments are made by the fund’s investors during the fundraising period.

Unlike in other financial assets, investors do not pay the committed capital in full in a single payment, but rather this deployment will be made in several payments during the investment period.

At Qualitas Equity Funds we seek to optimize the capital calls to investors and maximize cash management efficiency. Therefore, through different mechanisms we can homogenize the disbursement of the participants, while in a conventional private equity fund the disbursements are irregular and meet specific needs for capital.

Valuation method

The value of the investors’ position is calculated every three months.

The valuations of private equity funds are not subject to market comparisons, which protects their portfolios in temporary adverse situations as opposed to listed markets.

Furthermore, success fees on the portfolios of private equity funds are calculated only on the realised investments and not on their theoretical book value.

This means that even though the average returns of private equity portfolios are higher than those of other assets, their mid-term valuations are very conservative.

Fees

In funds of funds, the managing partner charges the fund a management fee to finance the ongoing costs of the fund’s activity.

On the other hand, it is usual to have success or carried interest fees.

This fee is generally applied after exceeding a pre-set minimum performance threshold (preferred return), which varies between managers and is usually between 7 and 10%. Linking the success fee to this minimum performance threshold (hurdle) aligns the managers’ interests with those of the investor, acting as a natural incentive to maximize investor returns.

Once the previous performance is exceeded, the returns obtained by the fund earn the percentage relative to this (success) fee in favour of the fund manager.

In any case, this fee is always generated based on the model included in the fund documentation and only after all the participants have received the capital invested plus the preferred return of their investment.

J-curve

According to various studies, private equity is the most profitable investment in the long term, with illiquidity being the price to pay for high returns.

The ‘J-Curve’ is just one example of this illiquidity.

In the first few years, the valuation of the investment was lower than the investment made. These are generally temporary and unrealized losses that are naturally corrected after 3 or 4 years.

The first reason that explains this ‘J effect’ is that at the beginning of the investments many expenses are necessary: due diligence, transaction costs, legal, operational changes in the companies…which are one-off costs related to the initial phase of an investment.

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The second reason is accounting, unlike other investments, in private equity you do not pay out the full amount committed at the beginning but spread those payments out over time. At the beginning, therefore, we have invested a very small amount, but it supports all the fund’s expenses.

In the long term, all these ‘J-curve’ effects dissipate.

Often, those approaching this asset for the first time, consider investing when the asset reaches its lowest value (around the third year), however, the closed nature of PE funds, prevents late investors from benefiting from this effect, against the initial investors, protecting them during the life of the fund.