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How do private equity funds work?

General partners and Limited partners

A fund is run by a fund manager, also referred to as a General Partner. Funds raise capital from investors. These investors are referred to as Limited Partners. Carbon Equity acts as an Limited Partner, on your behalf in a fund. The capital raised from investors is used to invest in companies.

Fund investment strategy

A fund will have an investment thesis. Such a thesis decides what opportunities the fund will focus on and those they won’t. A thesis can be broad - e.g. we invest in software climate technology companies or very specific - e.g. we invest in nuclear fusion deep tech companies.

Selection criteria

The investment strategy will feed into the criteria upon which a fund will decide to invest in companies. These criteria may include emission mitigation potential, the stage of the company, financial metrics, the technology etc. Funds will typically review hundreds if not thousands of opportunities a year and invest only in the top 1% opportunities.

Fund cycle

A fund will make investments during the first 3-5 years of its lifetime, known as the investment period. A fund may reserve a part of the capital raised to make follow-on investments in its most successful companies, also after the investment period.

Once the investment period is over, the harvesting period starts. During this period the GPs focus starts to gradually shift from value creation to generating liquidity for its LPs. Typically a GP will seek liquidity after holding an investment for 4 to 7 years. Exit methods include secondaries (a new PE fund), strategic sales (to a corporate for instance), or a public listing. Most funds are not fully liquidated after the initial 10-year fund term and ask for an extension to allow for the orderly exits of the remaining portfolio companies

Distributions

LPs will start to receive distributions once the GPs (partially) exit the first investments. Distributions to investors follow a predetermined order, called the ‘waterfall’:

  • Return of paid-in capital: 100% of the distribution will go to LPs until they have received an amount equal to what they have paid-in
  • Preferred return: 100% of the distribution will go LPs until they have received a pre-determined return (usually 8% p.a.) on the capital they have provided
  • Catch up: 100% of the distribution go the GP until they have received (”caught up”) with their share of the profit (”carried interest”, usually 20%). All distributions will flow the GP until the return is split 20% to the GP, 80% to the LPs.
  • Carried interest: Every additional distribution will be split 20% GP, 80% LPs (assuming 20% carried interest)

Note: there are several funds with a more GP-friendly waterfall (such as deal-by-deal carried interest). The funds Carbon Equity invests in generally follow the waterfall as described above (known as a ‘European waterfall’).

cash distributions
Return profile (the J-curve)

The return profile of a fund investment is commonly referred to as the J-curve. In the first years, LPs are contributing capital to the fund, leading to a negative cash balance. Once the fund begins to exit investments - the harvesting period - the net cash balance starts to improve. Typically in year 6-8 LPs have received back an amount equal to what they contributed. All the additional proceeds are profit.

J-cuve, indicative of cash flow scenarios assuming 13-year holding period

How can I invest in private equity?

There are several ways to invest in private equity (angel investing, crowdfunding, fund investing, etc), but we will focus on the two most common ways to gain exposure to this market.

Direct fund investments

Investors can invest directly in private equity funds, diversifying their capital over 10-30 investments per fund investment. Some investors have access to funds through their network, or meet the capital requirements (typically >5m per fund) to be allowed to invest in a fund. Carbon Equity equity offers the opportunity to invest directly into private funds starting at minimums of EUR100k.

Advantages of a direct fund investment

  • Let the experts within an industry (niche) navigate the ecosystem to diligence and surface the best investment opportunities.
  • Highly-qualified investment teams do the negotiations to ensure you pay a fair price for your ownership of the company.
  • Good teams don’t just bring capital to the table. They work throughout the full length of the investment to provide expertise, network and reputation to help companies grow.
  • 10-30 companies with one fund investment are better for your risk diversification.

Disadvantages of a venture capital fund

  • Typically, you need between EUR 5-10 mln to participate in a top venture capital or private equity fund.
  • To get into top funds at all, you usually need a strong network or a direct personal relationship with the VC fund.
  • You don’t get direct access to the company and its founders, meaning you won’t play a direct advisory role for the underlying companies.
Portfolio Fund investments

A Portfolio Fund investment, as know as a fund-of-funds or FoF investment, is an investment vehicle where one investment is spread across multiple private equity funds. A typical FoF selects between 5 to 10 underlying funds. So while one VC fund spreads your investment across 10-30 companies, a fund of funds spreads it across more than a hundred companies.

Advantages of Portfolio Fund investments

  • Let the fund selection experts within an industry navigate the ecosystem to diligence and surface the best VC fund opportunities.
  • Fund of Funds offer great diversification by investing in multiple funds with slightly different investment strategies, across stages, industries, etc.
  • Highly-qualified investment teams do the negotiations to ensure you are properly aligned with the VC fund managers.
  • Building a portfolio of 5+ funds requires a lot of time and active management. Fund of Funds managers handle all of these logistics for you.

Disadvantages of Portfolio Fund investments

  • Typically, you need a couple of million to participate in a top Fund of Funds
  • You don’t get direct access to the company, its founders or the fund manager, meaning you won’t play an advisory role for the underlying companies.
  • Fees for FOFs are typically higher than an individual fund because it includes both the management fees of the FOF and the underlying funds.

If you’re interested to learn more about the different ways to invest in private equity and the pro’s and con’s per strategy, read our deep dive on startup investing here.

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