Understanding Private Equity Cash Flows

by Michael Roth

From our experience working with 100s of participants on both sides of the market, there are lingering uncertainties and varying interpretations about how best to prepare and analyze cash flows. Our goal is to help GPs and LPs build and present cash flows in a consistent manner.

In the discussion below and subsequent pieces, I will detail how we at Bison think about cash flows and what we believe should be the industry standard. Our thinking closely aligns with the CFA Institute’s Global Investment Performance Standards (“GIPS”) and their Guidance Statement of Private Equity.

What is a fund?

A fund is an investment vehicle organized by a fund manager to make investments into companies. The fund is typically set up in a partnership structure and has three main components:

  • General Partner (“GP”) – the fund manager who is responsible for making investments and managing the fund’s cash flows
  • Limited Partners (“LP”) – the investors who commit money to the fund for the GP to invest. These include pension funds, endowments, etc.
  • Portfolio Company – the investments that are made by the GP

GPs call capital on an “as needed” basis, which means once they find an investment, they will request that LPs pay their allotted amount based on their overall commitment.

What is a contribution?

A contribution (or capital call) is a cash flow from the limited partners to the fund. In a cash flow spreadsheet, they should be negative amounts.

For gross cash flows, this includes:

  • The amount invested into portfolio companies
  • Transaction fees and expenses associated with completing the deal

Transaction fees and expense are included in the cost of the investment. For example, legal, advisory, or investment banking fees should be included in the cost of an investment.

For net cash flows, this includes:

  • Amount invested into portfolio companies
  • Transaction fees and expenses associated with completing the deal
  • Management fees

In the spirit of full disclosure, management fees should be their own line item so investors can effectively monitor the costs of the fund.

What is a distribution?

For a private equity fund, a distribution is a cash flow from the fund to the LPs. In a cash flow spreadsheet, they should be positive amounts.

For gross cash flows, this includes:

  • Cash distributed by the fund from a portfolio company
  • Stock distributed by the fund from a portfolio company

Cash distributions could either be from the sale of the company or from dividend payments paid by the company to the fund. If a manager distributes portfolio company shares to LPs, that distribution should be valued at the share price on the date the shares were distributed. GPs should note that LPs are unlikely to be able to sell those shares at the same price so they will ultimately place a different value on that distribution.

For net cash flows, this includes:

  • Cash distributed by the fund from a portfolio company
  • Stock distributed by the fund from a portfolio company
  • Carried interest payments

If the fund is in a position to make carried interest payments to the GP, they are usually netted out of the distribution at the time the distribution is made. Otherwise, carried interest is accounted for when calculating the NAV.

In the next piece, I will discuss recallable distributions and provide clarity on how industry players treat them and offer our view on how they should be treated.