A private equity fund is an investing group formed by private investors. These groups are structured as limited partnerships. They provide a way for wealthy investors to invest large sums with reduced tax obligations, and the size of their investments allows them access to markets not available to small investors.
The group that comes together to form the private equity fund consists of primary fund investors. They create a limited partnership in which they are the limited partners, which means they receive returns on investments but do not have direct control over the assets. The general partner, who does have that control, is usually a limited liability company set up by the primary fund investors. They may hire an outside entity to act as manager of the fund. The manager decides how to build the fund’s portfolio.
After the fund reaches a certain level of commitment, it is typically closed to additional investment. There are, however, two ways to invest in a private equity fund after the initial commitment period. One is secondary fund investment, in which an investor purchases a share in the portfolio once it has started realizing returns. This is available only after the fund satisfies its obligations to the primary fund investors. The second is co-investment, which is available when a manager decides that an investment is too big for the fund’s portfolio and asks the primary fund investors to invest directly in the company by pooling their money with that of the fund.
The types of investments that any particular fund can make are outlined in its constitution. Profit is not the only consideration. Private equity fund managers can tarnish their reputations by investing in morally questionable businesses because the investments of the funds go beyond simple stock purchases — the funds become involved in the companies in which they invest.
Private equity funds generally engage in three types of investment behavior: buyouts, venture capital and mezzanine financing. In buyouts, the private equity fund purchases a failing company and restructures it, reaping the benefits of the company’s turnaround. Venture capital investments are sums of money given to start-ups in return for a share of profits. Mezzanine financing, which is primarily used to finance other types of investment, is subordinated debt that generates short-term returns that grow with the cash flow of the company. Private equity fund investments are risky, and their success depends on the fund manager’s ability to identify promising prospects.