Understanding Drawdowns in Private Equity: A Comprehensive Guide
What is Drawdown in Private Equity?
The process of a private equity firm demanding a portion of the committed funds from limited partners to finance a newly discovered investment or expenditure is known as a drawdown, also commonly referred to as a capital call.
Setting Up a Private Equity Fund
A private equity fund is established by soliciting commitments from investors. Once the General Partners (GPs) receive the required commitments from investors, the fund is declared closed.
However, it is not as though all the investors have immediately provided the funds. The GPs and their investment/advisory teams are on the lookout for investment opportunities. When the due diligence process is completed on a target company, and an investment is warranted, the GPs will request investors to remit money corresponding to their commitments.
An Illustration of Drawdowns
For example, if an investor has committed to a 20 million fund within a 1 billion total fund, and the GPs wish to invest 80 million in a particular company, the investor will be asked to remit 1.6 million (8% of their commitment).
Elements Included in Drawdowns
Drawdowns can also include fees for the fund manager, as well as expenses related to the transaction such as legal or accounting fees.
Why are Drawdowns in Stages?
A pertinent question might be, why are these drawdowns made in stages instead of taking the money upfront. The rationale is that the performance of PE funds could be negatively impacted if they drawdown cash and there is a lag between the drawdown and the actual investment deployment.
Drawdown Period Planning
To assist investors in planning their cash outflows and to set appropriate goals for the PE fund managers, each fund provides a drawdown period. For instance, a 10-year fund life might have a 4-year drawdown period.
Non-Sporadic Nature of Drawdowns
Drawdowns are not sporadic; instead, there is an administrative process and associated costs. Therefore, funds plan to drawdown in quarterly or bi-annual stages, combining investments and expenses over a period before issuing a drawdown call.
Drawdown Period Extensions
If within the drawdown period, not all the money has been invested, the fund may seek a vote to extend the drawdown period or not withdraw the uninvested balance altogether.
Conclusion
Understanding the principles behind drawdowns in private equity is crucial for both investors and fund managers, allowing for better planning and execution. If you have any follow-on questions, please feel free to ask!