In the world of real estate investment, success often hinges on one’s ability to navigate the complex landscape of financial strategies and investment vehicles. One such strategy that has gained significant prominence in recent years is private equity. When an investor starts looking at private equity investments, they will quickly notice there is some unique terminology used describing the performance of the investment. To keep this from being a mental roadblock, we want to help the potential investor understand a few of the commonly used terms.
Private Equity Meaning
Let’s start by demystifying the term “private equity.” At its core, private equity represents an investment strategy where capital is invested in private companies or assets not traded on public stock exchanges. The goal of private equity firms is to acquire ownership stakes in these businesses, with the aim of driving growth and profitability.
Private equity investments often involve a hands-on approach. Unlike passive investments in publicly traded stocks, private equity firms actively participate in the management and decision-making processes of the companies they invest in. This level of involvement allows them to influence the company’s strategic direction and create value.
Understanding Private Equity
Real Estate Private Equity
Now that we have a grasp of private equity’s general concept, let’s delve into its specific application in the real estate sector. Real estate private equity, as the name suggests, involves investing in private real estate assets or companies. These investments can encompass various property types, such as residential, commercial, industrial, or even development projects.
Real estate private equity firms seek opportunities to acquire, develop, or reposition properties to increase their value. This often involves a combination of financial engineering, operational or management improvements, and strategic planning. Unlike traditional real estate investments, which may involve purchasing properties directly, real estate private equity focuses on enhancing the performance and profitability of the assets.
Private Equity Fund
Many private equity investments are made through specialized investment vehicles known as private equity funds. These funds pool capital from a group of investors, known as limited partners (LPs), and are managed by the private equity firm, which acts as the general partner (GP).
LPs entrust their capital to GPs, who are responsible for making investment decisions and managing the fund’s portfolio. In return, GPs receive management fees and a share of the investment profits, aligning their interests with those of the LPs.
Private Equity vs Venture Capital
To better understand private equity, it’s essential to distinguish it from venture capital. While both private equity and venture capital involve investing in private companies, they differ significantly in their focus and objectives.
Private Equity primarily targets mature companies that are already established in their respective industries. These companies may require additional capital for various reasons, such as expansion, acquisitions, or restructuring. Private equity firms step in to provide the necessary funds and expertise to help these companies achieve their goals.
Venture Capital, on the other hand, is geared toward startups and early-stage companies with high growth potential. Venture capitalists invest in these companies in exchange for equity, with the hope that they will grow rapidly and generate substantial returns in the long run.
Hedge Fund vs Private Equity
It’s essential to draw distinctions between private equity and another investment vehicle often mentioned in the financial world: hedge funds.
Hedge Funds are investment funds that aim to generate returns for their investors by employing a variety of strategies, including long and short positions, derivatives trading, and leverage. Unlike private equity, hedge funds are not typically involved in the direct management of the companies or assets they invest in. Instead, they focus on trading and market speculation.
While both hedge funds and private equity funds are considered alternative investments, they have different risk profiles, investment strategies, and liquidity characteristics. Hedge funds tend to offer more frequent liquidity options, while private equity investments often involve longer-term commitments.
Preferred Return
This is simply the amount (a percentage) that is dedicated to the limited partners (you and other investors) before the general partner receives any funds.
For example, if you invested $200,000 and there was a 7% preferred return you would receive $14,000 per year during the life of the investment. The preferred return is the first tier that is paid out with priority given to the investors.
The Split
This is how profits are divided up between the general partner (sponsor) and the limited partners (investors). After investors receive all their original investment capital back, then distributions exceeding the 7% preferred return follow a split as enumerated by the operating agreement between the general partner and the limited partners. An example would be a distribution of remaining profits up to 15% internal rate of return (IRR) being split 70/30 between the limited partners and the general partner.
If and when the investment’s performance exceeds 15% IRR there is what is called a waterfall. Waterfall distributions are split between the partners according to the operating agreement. An example of this might be a 50/50 split between the limited partners and general partner of all the profits exceeding a 15% IRR benchmark.
Internal Rate of Return
The internal rate of return is not unique to private equity, but since it is integral to the distribution waterfall, we will touch on its meaning. The IRR is the intrinsic rate of return that is expected from an investment factoring the amount and timing of cash flows. The IRR is the discount rate that makes the net present value equal to zero in a discounted cash flow analysis. What this tells us is the percentage rate earned on each dollar invested for the period of the investment.
Distributable Cash Flow
The last term we are going to cover is distributable cash flow – since this is central to all the above. Distributable cash flow is the income received from the investment (not counting capital contributions), less the portion used to pay expenses, make capital expenditures, and fund reserves. This is the primary source of revenue for a multi-family property investment until it is sold and capital gains are realized.
At Mission Bay Capital Partners, we specialize in real estate private equity investments, helping our clients navigate this dynamic and rewarding sector. If you’re interested in exploring the world of private equity in real estate or have any questions, please don’t hesitate to reach out. We’re here to assist you on your journey to successful real estate investments.
For more resources, you can watch our webinar series to learn more about multi-family real estate syndication.
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