Private equity is an alternative asset class where general partners from a private equity firm raise funds from limited partners and deploy the LP’s invested capital to acquire and manage a public or private company for a holding period of about 5 years before selling it for a profit or taking it public via an IPO. Compared to venture capital, private equity firms usually fund and invest in more mature companies that generate revenue instead of pre-revenue startups.
As with every industry, private equity has unique terminology, a mix of acronyms, financial jargon, and legalese. In this article, we go over the most common terms in private equity you will encounter as someone trying to get into the industry or as an executive or owner whose company is being acquired by a private equity firm.
Before getting started with the term glossary, these are the different styles of private equity investing:
A Buyout is when one party acquires most of a company’s equity. A buyout usually happens when the buyer sees an opportunity to make a good return on investment by making operational and management changes.
A Leveraged Buyout (LBO) is similar to a buyout but uses debt to purchase the company’s equity. A leveraged buyout enables those purchasing the firm to acquire large companies without committing large amounts of capital. Since many firms have strong cashflows and assets, investors secure the debt against the company’s cashflows and pay it off using future cash flow.
Distressed/Turnaround is when a PE firm cheaply acquires a company in financial trouble or distressed and restructures it to profitability and sells it for a profit after a period of time.
Growth Equity: This is capital invested in an established, growing company. Growth equity comes into play further along a company’s lifecycle once it is past the startup stage and needs additional capital to grow.
Below are the most common terms in the private equity industry.
Acquisition Finance: The different sources of capital deployed to support a merger, acquisition, or series of acquisitions in debt or equity. Acquisition finance is usually procured from various sources offering the lowest capital cost.
Accredited Investor: Defined by rule 501 of Regulation D, an accredited investor is a natural person who has an individual net worth or a joint net worth with their spouse that exceeds $1 million or an income exceeding $200,000 for the two most recent years or a joint income of $300,000 for those years. Accredited Investors have more investment opportunities than non-accredited investors.
Add-on Acquisition: An add-on or bolt-on acquisition is where a private equity portfolio company, also known as the “platform,” acquires another company to help its portfolio company grow. For example, an add-on can help a company expand in a specific geography, product line, customer base, etc. The private equity firm that owns the company usually manages the process.
Alternative Asset: This asset class is not the traditional asset class of cash, equities in public companies, and bonds. Alternative assets or alternative investments include real estate, derivatives, private equity, venture capital, etc. Traditionally, these kinds of investments are riskier than traditional assets but also have the potential to generate higher returns. Most alternative assets are only open to accredited investors.
Amortization: An accounting term referring to distributing the cost of an intangible asset over its useful life. Examples of intangible assets include patents, trademarks, costs of issuing bonds and raising capital, etc. The term can also be used in another context, such as an amortization schedule to calculate the loan payments that include principal and interest.
Antitrust Laws: A type of law that prohibits or discourages the concentration of a company’s market power and the creation of monopolies. In the USA, some examples of antitrust laws include the Sherman Act and the Hart-Scott-Rodino Antitrust Improvements Act (HSR), which require the parts of a proposed acquisition to file a series of forms with the government that provides detailed information about the companies and the transaction.
Asset-Based Lending: A type of lending secured by the borrowing company’s assets. This gives the lender priority in claims to the creditors if the company goes bankrupt or defaults.
Carried Interest: “carry,” or profit participation, is the share in the profits that the general partners from venture capital or private equity firm received from the fund. Usually, carried interest is 20% of a fund’s profits. Carry is a performance fee that rewards the manager for enhancing the fund’s performance. Funds also charge a management fee of 2% on top of the carried interest.
Capital Commitments: When an investor in a PE fund has committed to investing a specific amount of capital in a fund, the capital is not invested at once. Instead, it is called by the fund over time.
Capital Call: This occurs when the GP at a private equity or venture capital fund asks the limited partners or investors to provide a portion of the capital they committed to the fund.
Capital Gains: The increase in the value of an investment. A capital gain is realized when the investor sells the investment and realizes the gains. In private equity, gains are realized during a liquidity event when a fund sells a company to new investors or the company goes public via an IPO.
Co-investment occurs when a private equity fund’s limited partner invests directly into a fund’s portfolio company alongside the fund. Co-investment is usually limited to large institutional investors who already have a relationship with the fund manager. Co-investment is not available for smaller retail investors.
Due Diligence: The process of evaluating and assessing a potential investment in a company or an investment fund. PE firms conduct company due diligence on target companies to determine what deals should be pursued and which should be passed over. Due diligence usually covers the management team, the business strategy, the finances, operations, and the legal side. When done properly, the due diligence process minimizes the risks and maximizes the value for the PE firm and all LPs. Potential investors in the fund should also conduct their due diligence before committing capital.
EBITDA: This is an accounting metric that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA measures cash flow as revenue minus expenses (excluding taxes, depreciation, and amortization). EBITDA is especially useful when conducting financial analysis since it shows a company’s cash generation level.
Endowments: The total available investible assets of a nonprofit institution. Institutions invest their endowments and use the resulting income for a specific purpose, including funding specific programs and the institution’s operations. Most endowments keep the principal amount intact while using the investment income. Large educational, cultural, and religious organizations have endowments invested in different asset classes, including equities, hedge funds, and more illiquid investments like venture capital and private equity. The asset class allocation depends on the institution’s goal and investing philosophy.
Enterprise Value: A measure of a company’s total value. The enterprise value calculation includes the market capitalization of a company but also short-term and long-term debt and any cash or equivalents in the company’s balance sheet. The common equitation for EV= fully diluted market capitalization + minority interests + market value of preferred stock + capital structure debt – cash and equivalents. There are other versions of this formula that can also be used.
PE Fund Structure: A private equity fund is a closed-end investment vehicle, meaning there is a limited amount of time to raise funds, and once that window has elapsed, no further funds can be raised. PE funds are usually formed as a limited liability company or a limited partnership.
Fund of Funds: An investment strategy of holding a portfolio of funds instead of investing directly in securities. For example, some investment funds only invest in private equity funds- these would be considered funds of funds.
Internal Rate of Return (IRR): In private equity, IRR refers to the annualized rate of return from a series of cash flows relating to the fund. Gross IRR is the return a fund receives on its portfolio investments. The final IRR can only be calculated once the fund has been liquidated and all the value has been paid to the limited partners.
Hurdle Rate: This is the minimum return a fund must achieve for investors before the general partners can share the profits. Hurdle rates are cumulative and compounded annually and are measured using the IRR or a multiple of the initial investment. The hurdle rate is also known as the preferred return.
Initial Public Offering (IPO): The first time a company sells stocks to the public via a stock exchange. Usually, the IPO process requires a company to work with an investment bank to manage the offering and file the required registrations with the Securities and Exchange Commission (SEC).
Management Team: A group of high-level leaders hired by business owners to take on the essential responsibilities of running the company. This includes the CEO, CFO, and other C-level and VP positions.
Management Buyout (MBO): Similar to a leveraged buyout, an MBO is when a company’s management team purchases the business. This is appealing to some management teams because of the greater potential of rewards and control that comes with being owners of the business instead of employees.
Mezzanine Debt: Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert the debt to equity interest. Typically used in leveraged buyouts, mezzanine debt is subordinate to a company’s bank debt but senior to all equity.
Residual Value Paid in Capital (RVPI): Measures the residual value of a private equity fund as a multiple of the capital paid by all investors. The residual value is the current fair market value of all assets the fund holds, and the investors’ paid-in-capital is the total of all contributed capital up to that time. RVPI is a good measure to gauge the current value of a fund’s assets relative to the initial investment.
Private Equity Investor: As an alternative investment, private equity is open only to accredited investors and qualified clients. These include High net worth individuals, institutional investors such as insurance companies, endowments, pension funds, etc.
Subordinated Debt: Any debt that ranks after other types of debt if a company falls into bankruptcy or liquidation.
Venture Capital: A form of private equity financing provided to early-stage companies with high growth potential. Companies use the capital invested by the VC firm as working capital to grow the business, and, in exchange, the VC fund takes a percentage of ownership (equity stake) in the business.
These are just some of the industry terms. Are there any other terms we should add to the list? Let us know.
We have also compiled a similar glossary with the most common terms used in venture capital. To read it, click here.