Outline the structures through which private assets can be held and contrast their features.
The idea
Private assets are held through several structures. The standard private equity fund is a closed-end limited partnership. The general partner (GP) manages, limited partners (LPs) commit capital that is drawn through capital calls, and the fund lives about ten years. The GP earns a management fee, often on commitments, plus carried interest, usually 20 percent of profits above a preferred return. Carry is paid under a whole-fund (European) or deal-by-deal (American) waterfall, with a clawback if early carry proves excessive. Open-ended or evergreen funds allow periodic subscriptions and redemptions but then face liquidity mismatch and gating. Listed vehicles give daily liquidity but trade at premiums or discounts to net asset value and move with equity markets. Funds of funds add diversification and a second layer of fees. Separate accounts give control and customisation at the cost of scale and governance burden. Direct and co-investment avoid fund fees but need in-house capability.
A practice question
Compared with an unlisted private equity limited partnership, a listed private equity vehicle is best described as having:
- a share price that always equals net asset value because arbitrage keeps the two in lineWhy not: Arbitrage is limited because the underlying assets cannot be traded; listed vehicles often trade at discounts or premiums.
- lower correlation with public equities, because the underlying companies are privateWhy not: Shares trade in the equity market and are driven by equity sentiment, so correlation is higher than reported NAV suggests.
- a ten-year lock-up with capital calls drawn by the sponsorWhy not: Describes the unlisted fund; a listed vehicle is fully funded and investors can sell on the exchange.
- daily liquidity, but a share price that can differ from net asset value and tends to move with public equity markets - correct
Listing provides liquidity and small ticket sizes, but the price reflects supply and demand and often trades at a discount to NAV. The market price therefore moves with equity markets, unlike appraisal-based NAVs.
A harder one
An underlying private equity fund earns a 15 percent gross return, charges a 2 percent management fee and takes 20 percent carried interest on the profit after the management fee. A fund of funds that holds it charges its own 1 percent fee and takes 10 percent carry on the return after that fee. Ignoring hurdles, the net return to the final investor is closest to:
- 8.5 percent - correct
- 10.4 percentWhy not: Stops at the underlying fund's net return and omits the fund of funds layer entirely.
- 9.4 percentWhy not: Subtracts the fund of funds management fee but leaves out its carried interest.
- 12.0 percentWhy not: Subtracts only the two management fees (15 - 2 - 1) and ignores both layers of carried interest.
Underlying net = (15 - 2) x 0.8 = 10.4 percent. Fund of funds net = (10.4 - 1) x 0.9 = 8.46 percent. Each layer takes its own fee and carry, so layering fees can cut the net return well below the underlying fund's.
The hardest tier
A fund of USD 100 million charges 20 percent carried interest with no hurdle and no fees. It invests USD 50 million in each of two companies. Company A is sold for USD 90 million. Later, Company B is sold for USD 20 million. Under a deal-by-deal waterfall the GP is paid carry after the first sale, and the partnership agreement requires a clawback. The amount the GP must return at the end is closest to:
- USD 8 millionWhy not: This is the carry paid after the first sale (20 percent of the 40 profit); it is what the GP received, not what it must return.
- USD 2 millionWhy not: This is the carry the GP is entitled to on the whole fund (20 percent of the net 10 profit), not the amount to be returned.
- USD 6 million - correct
- USD 30 millionWhy not: Treats the whole loss on Company B as the clawback; the clawback only restores the GP to its whole-fund entitlement.
Deal-by-deal carry after the sale of A = 0.2 x 40 = 8. Over the whole fund profit = 40 - 30 = 10, so the GP is entitled to 0.2 x 10 = 2. Clawback = 8 - 2 = USD 6 million. A whole-fund (European) waterfall avoids this interim overpayment.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Private Markets Investing (up to section 3.3.10)
- Account for why investors choose to put money into private markets.
- Use and contrast the various ways of measuring private equity performance, outlining the strengths and weaknesses of each.
- Show how investors in private markets come to face different risks and judge how those risks can be measured.
- Characterise co-investing in private markets and weigh up its benefits and drawbacks.
- Explain what investors gain and what obstacles they meet when they reach private markets by way of a pooled vehicle like a private equity or private debt fund.