Interim Fund Performance and Fundraising in Private Equity

The Fuel of Private Equity

The private equity industry is driven by the capital that supports its investments. Without a proper source of funds, private equity firms would not exist. The industry’s main objective is to allocate capital on the behalf of others and produce a return. The money that is raised from investors is called equity. In most cases, the funds available from equity raising are not sufficient to execute an investment strategy, so private equity firms look to lenders to supplement the lack of capital. Both debt and equity work together to fund an investment, but each method of fundraising has its own set of pros and cons. Collectively, the sourcing of debt and equity is referred to as fundraising. Fundraising is a crucial first step for private equity firms that can make or break an investment strategy.

Equity Placement

For publicly traded companies, equity can be raised through an initial public offering (IPO). In this scenario, anyone with a little bit of money and a brokerage account can contribute their equity to the company/investment. Private equity firms do not raise equity in the same manner, hence the name private equity. Private equity firms will look to family offices, wealthy individuals, or institutional investors as a source of capital. The difference between this and a publicly traded asset is that private equity is only available to those who can afford the minimum investment amount. Additionally, you need to be connected in the private equity investment world to even be aware of the investment opportunity. As private equity firms become more established, the barrier of entry for investors becomes more stringent. On the other hand, if a private equity firm is struggling to find investors, they can hire a company to source equity for them. The act of sourcing equity for a fund is called equity placement. These equity placement companies charge a fee to the private equity firm for their services.

Debt Financing

Once a private equity fund has reached its desired equity amount for a project, it will begin looking to lenders to fund the remaining portion. In real estate private equity, there are 3 common forms of debt: construction debt, senior debt, and mezzanine debt. Construction debt is a short-term loan that is used to fund the development of a real estate project. Construction loans typically have higher interest rates as the risk associated with the project development is much higher than a traditional project loan; furthermore, construction loans are usually interest only. Senior debt has priority over other debts as it gets paid back first in the case of asset liquidation. Since senior debt has priority, it charges a lower interest rate. Mezzanine debt on the other hand sits lower in the priority of payback. Because of the added risk, mezzanine debts charge a higher interest rate compared to senior debts.

Interim Fund Performance and its Relation to Financing

Fund performance is the strongest tool that private equity firms have in the fundraising arena. Fund performance acts as a credit check for any potential investors or lenders. Although past performance cannot predict the future, preceding fund performance can give prospective investors/lenders a benchmark for what to expect. With a proven track record, private equity firms can more easily raise capital. For new funds, this track record is not available, making it more difficult to raise funds.

The fund quarterly report acts as a source for fund performance benchmarking. The quarterly report generally contains information on portfolio composition, interim performance, market analysis/outlook, asset breakdowns, and audited financial statements. The in-depth coverage and frequency make the quarterly report a fantastic resource for existing investors, prospective investors, and lenders. Eventually, a strong track record can eliminate the process of equity raising as investors begin to seek out the fund. This dynamic change is an example of how interim fund performance is crucial in relation to fund raising.