Private Equity (1/2)

Other than hedge fund, another innovative financial instrument drawing the attention of global regulators is private equity.

According to an article in Wikipedia, "private equity" is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on the public market. Passive institutional investors may invest in private equity funds, which are in turn used by private equity firms for investment in target companies. Categories of private equity investment include leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others. Private equity funds typically control management of the companies in which they invest, and often bring in new management teams that focus on making the company more valuable.

The salient features of private equity include longer investment horizon and lack of liquidity (as there are many transfer restrictions on private securities). Private equity firms generally receive a return on their investment through one of three ways: (a) IPO; (b) sale or merger of the company they control; or(c) recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund which pools contributions from smaller investors.

Private equity funds are generally organized as limited partnerships which are controlled by the private equity firm that acts as the general partner. The fund obtains capital commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at which time each limited partner funds a pro rata portion of its commitment. All investment decisions are made by the general partner, who is typically compensated with a management fee (as a percentage of the fund's total equity capital) as well as a performance fee (based on the profits generated by the fund).

Most private equity funds can only be offered to institutional investors and individiuals of substantial net worth as they are generally less regulated than ordinary mutual funds. Given the significant growth in capital flowing into private equity funds, FSA has recently issued a comprehensive discussion paper about the regulatory framework of private equity. I will blog it tomorrow.