Private equity (PE) refers to investment funds that buy and manage private companies, aiming to improve their value before eventually selling them for a profit. Unlike public companies whose shares are traded on stock exchanges, private companies are not available for public trading. Although the Singapore market was among the best performers last year because of the local banks, the delistings are increasing at an alarming pace.
Since the start of the year, three companies have proposed privatisations, including the sponsors of Paragon REIT whose market capitalisation is $2.79 billion.
Parts of PE are becoming accessible to high net-worth individuals and accredited, and most recently to retail investors via the Astrea bonds.
For years, PE offered higher returns than traditional investments like stocks and bonds. It also provided diversification for your investment portfolio as it is less correlated with public market fluctuations.
Types of PE funds
There are several types of PE funds, each with its own strategy and focus:
See also: Democratising private equity
• Leveraged Buyout (LBO) funds use borrowed money to buy companies, aiming to make them more profitable.
• Venture Capital (VC) focuses on early-stage startups with high growth potential.
• Growth Equity invests in mature companies looking to expand or restructure.
See also: Temasek-owned Seviora discusses private markets
• Distressed PE targets struggling companies with the potential for a turnaround.
• Secondaries or secondary funds invest in existing PE funds or portfolios where the LPs want to exit.
• Funds of Funds are pools of investments into multiple PE funds. Infrastructure funds focus on long-term investments in infrastructure projects.
• Real Estate PE funds are one of the more common types of PE in Singapore and invest in real estate.
• Finally, mezzanine capital provides companies a mix of debt and equity financing.
Accessibility to PE has changed over the decades. Traditionally, private equity was the purview of high-net-worth individuals and institutional investors. However, there are now options for retail investors. These include specialised PE ETFs, mutual funds, and publicly traded PE firms such as Blackstone Group, Apollo Global Manager and The Carlyle Group.
Closer home, CapitaLand Investment is increasingly focusing on private real estate funds, while Keppel is in the alternatives management space.
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Know your fees
A bugbear among some investors is fees. PE funds typically charge fees to their investors through two main types: management fees and performance fees (also known as carried interest). Singapore investors had a taste of how PE worked when City Developments launched its profit participation securities (PPS), including how the returns and profit, if any, were distributed.
Management fees are designed to cover the operational costs of managing the private equity fund. They are usually charged annually and are a percentage of the total committed capital (the total amount of money the investors have pledged to the fund). The typical range for management fees is around 1.5% to 2.5% per year.
Performance Fees or carried interest are designed to incentivise the fund managers to generate strong returns. These fees are a percentage of the profits generated by the fund and are typically taken after the investors have received a minimum return (called the hurdle rate). The standard percentage for carried interest is around 20% of the profits.
Chasing waterfalls
A waterfall in PE refers to the method used to distribute profits between the investors (limited partners) and the fund managers (general partners). It is called a “waterfall” because it prioritises the flow of profits in a series of steps, much like water cascading down a series of levels.
The waterfall comprises return of capital, hurdle rate, a catch-up and carried interest. At the end of a fund life, investors or LPs receive their initial capital contributions back. This ensures that their invested money is returned before any profits are distributed.
Next, investors receive a preferred return, which is a predetermined rate of return on their invested capital. This rate is usually around 8% per annum but can vary. The purpose is to ensure investors get a minimum return on their investment before the fund managers receive any performance fees.
Once the preferred return is paid, there is often a “catch-up” phase where the fund managers receive a portion of the profits until they have “caught up” to a certain percentage of the total profits. This phase aligns the interests of both the investors and the managers.
Finally, the remaining profits are split between the investors and the fund managers according to the carried interest. A typical split might be 80% to investors and 20% to fund managers, but this can vary.
