Private Equity Types + Real Estate Development Funds Explained
Today we talk about the main types of private equity funds as well as the specific subset that BAI Capital works with: Real Estate Development Funds.
This article will concisely explain the differences in these investment types as well as the advantages of investing in real estate as a development partner/ co-owner.
We begin with the 5 main types of private equity funds, but first, a simple definition of Private Equity.
Private equity funds are pools of capital to be invested in companies that represent an opportunity for a high rate of return. They come with a fixed investment horizon, typically ranging from four to seven years, at which point the PE firm hopes to profitably exit the investment. Exit strategies include IPOs and the sale of the business to another private equity firm or strategic buyer.
Private Equity Funds – The 5 main types
Leveraged Buyout Funds
Typically acquire controlling stakes, either alone or in partnership with other PE firms, of mature, cash-flow-stable companies.
Venture Capital Funds
Usually invest in minority stakes in startup companies, often in high-growth sectors like internet and consumer technology, bio-tech and healthcare technology, and energy.
Growth Capital Funds
Invest in mature businesses that are looking to scale operations (organically or through M&A) and enter new markets.
Fund of Funds
They are an investment plan in which funds are invested in other equity funds.
Real Estate Funds
These are capital raises used to acquire, operate, develop, & sell buildings to then create returns to their investors.
What is Real Estate Private Equity ( or Real Estate Development Funds)?
Real Estate Private Equity firms raise capital from private investors and deploy that capital to make investments in real estate. They engage in five key activities:
Screening investment opportunities
Acquiring or developing properties
Capital Stack in Real Estate Development Funds
Debt is paid out first, with the senior institutional loan acting like a de-facto mortgage, followed by mezzanine loans, which are instead secured by an interest in the borrowing entity. Debt financing also receives the least amount of interest: 4-8%, and 12% respectively.
Preferred equity sees annual coupon fixed returns of 8% +, plus a kicker or upside of additional profits, realized upon fund close. Preferred equity is secured by the ability to force the sale of a property if needed.
Common equity shares are paid out last, but also hold the position of unlimited upside. As part of their agreement to finance a project, a lender will require that the borrower (or General Partner) invest their own money to ensure they have a vested interest in the success of the project.
Waterfall of Distribution when Fund Closes
Because the developer has a vested interest in the success of their project, all attempts to ensure a profitable outcome are put in place. Should misfortune occur, all investors above the developer and other common shareholders are paid out first.
In terms of a partial exit, there could be a private placement, where another investor purchases a piece of the business. Another possibility is corporate restructuring, where external investors get involved and increase their position in the business by partially acquiring the private equity firm’s stake. Finally, corporate venturing could happen, in which the management increases its ownership in the business.
As noted above, investors higher in the capital stack get paid out first, but at a lower interest rate. In other words, less risk, less gain…
Advantages of Investing in Real Estate Development Funds
Hedge against Inflation
Annualized returns from property investments usually outpace inflation.
Multifamily properties are typically viewed as one of the least risky forms of real estate investment.
Passive Mid-Term Investment
Investing in a development project is a hands-off, multi-year investment that requires no involvement on the part of the investor.
Diversification against Stocks and Bonds
The housing and property market is quite independent of the stock market as real estate price movements tend to have a low level of correlation with publicly traded securities.
Incentive Alignment for Investor
Preferred investors have a reciprocal incentive alongside the developer as the latter gets paid after the former. In other words, the payout to the developer is reliant on performance.