Private Capital
Why this chapter
To understand how the funds that buy up whole companies are built, and why a promise to invest money is not yet money.
An analogy
Picture a cooperative that clubs together to buy orchards. The members do not bring money at once: they sign a paper saying they will put in their share when the head of the cooperative finds a suitable orchard and calls. The call can come at any moment over the next few years, and there is no refusing — otherwise you lose everything you put in before. The head takes a fee for the work every year and, on top of that, keeps a fifth of the profit, but only after the members have got back what they put in and received an agreed minimum. The sixteenth chapter is about exactly that arrangement: about promises instead of money, about the queue for profit, and about what happens when the orchards do not sell.
How it works
A private capital fund is a partnership for 10+2 years: the LPs sign a commitment (a promise, not money), and the GP draws it down in pieces through capital calls for specific deals. The economics of “2 and 20”: a management fee of ~1.5–2% (often on committed capital!) + carried interest of ~20% of the profit (after the LPs get their capital back and a preferred return of ~8%; the catch-up then levels the base up to “20% of all the profit”) — the European waterfall.
Liquidity is the main currency: the J-curve (in the first years the fund is under water), the IRR is inflated by subscription lines — believe DPI, not IRR. Semi-liquid “perpetual” funds (BREIT) promise monthly redemptions against illiquid assets — a banking mismatch in fund clothing: BREIT's gates — filling redemption requests pro rata — ran 15 months in a row (November 2022 to January 2024).
Private credit (~$2 trillion) is a bank without a license: it lends but creates no money (it moves the unitholders' money around) and does not fear a run (the capital is locked). Systemic risk comes back through the back door — the bank leverage of the funds. The investor's view: in the world of funds the main questions are whose money it is, whose liquidity it is, and who sets the price (NAV marks look “calmer” than the exchange, right up until you ask for your money back).
The words of this chapter
Commitment and capital call
A commitment is a signed promise to invest a sum. A capital call is a demand to pay in the next part of it for a specific deal.
It was invented so that investors' money does not sit idle for years: the manager calls it in as it is needed.
The management fee
An annual payment to the manager, usually around 1.5–2% a year. The key question is what sum it is counted from: the amount promised or the amount actually invested.
It was invented as payment for keeping the team going in the years when there is no profit yet.
Carry
The manager's share of a fund's profit, usually around 20%. It is paid after the investors have got back what they put in and received an agreed minimum return.
It was invented so that the manager earns together with the investors and not only on fees.
J-curve
The shape of a fund's life: first years of losses from fees and immature investments, then, if you are lucky, a rise as companies are sold.
It arises by itself: the manager starts being paid at once, while the companies are sold years later.
IRR against DPI
The first measure counts the return with the time the money was held taken into account; the second counts how much real money has already come back per unit invested.
They have to be separated because the first is easy to manage: push the calls to investors back by borrowing against their promises, and the money works for fewer days while the percentage rises on the same profit.
A gate
A limit on taking money out of a fund: requests are met only partly if there are too many of them.
It was invented as an honest safety valve for funds that promise frequent payouts while owning illiquid property such as buildings.
Private credit
Credit funds that have replaced banks in financing deals. They lend but create no money: they move the money of their own investors.
They grew up where it became expensive for banks to hold such loans: they require too much capital — the owners' money.
What happens to the balance sheet
See how a fund like this differs from a bank. A bank creates money when it lends, and it fears a run, because its obligations can be presented at any moment. A credit fund creates nothing: it moves the money of its investors, which is locked up for years, and it fears no run at all. But it has a disease of its own: promising frequent payouts while owning illiquid assets is the very same maturity gap in different clothes. And there is a shared link: funds work on bank leverage, so their trouble comes back to the banks.
Where the money comes from here
The manager earns three times over: an annual fee for the work, a share of the profit after the investors' money has been returned, and the income of its own funds. The investors earn on the sale of the companies that were bought, but they pay for it with years of illiquidity and with the need to hold a free store of money against the calls. The bank earns interest, lending both to the funds' deals and to the funds themselves. The one who loses is whoever confused an opinion with a fact: a pretty percentage return with almost no money actually back. Here is why this matters to you: in any product promising regular payouts, read the limits on withdrawal first and everything else afterwards. A product's liquidity is never higher than the liquidity of its worst asset.
What people usually get wrong
The common belief. Once you have signed an obligation to invest, the money is as good as handed over.
What is actually true. It is a schedule, not a transfer. The manager calls the money in parts for specific deals, and the call can come at any moment over several years.
The common belief. A fund's high percentage return proves the manager's skill.
What is actually true. That figure depends on how many days the money actually worked. By taking a loan against the investors' promises and pushing the calls back, a manager raises the percentage without earning one extra som.
The common belief. A fund that promises monthly withdrawals is liquid.
What is actually true. If it owns buildings, its liquidity equals the liquidity of the buildings. One large fund of that kind limited its payouts for 15 months in a row.
After this chapter you will be able to
- tell a signed obligation apart from money received, and hold liquidity against somebody else's schedule of calls
- read a return through the time the money was held, and tell a percentage per annum apart from the sums that actually came back
- read the queue for money in an agreement and see whose claim is senior to yours
- judge a product's liquidity by the liquidity of its worst asset, not by the promise in the prospectus
- work out from a single entry whether a lender creates new money or only moves somebody else's
Check yourself
An investor signed an obligation to put a large sum into a fund. When will they actually part with the money?
In parts, when the manager calls.
The promise is a schedule, not a transfer. The money is called in for specific deals over several years, and all that time the investor has to keep a free store of money that earns nothing.
A credit fund made a loan to a company. Is there more money in the economy?
No.
The fund moves its investors' money: a balance simply changed owner. Only a bank can create new money. Hence the difference in their fears too: a bank is afraid of a run and a fund is not, because its money is locked up.
A property fund promises monthly payouts and has limited them for 15 months in a row. Is that a deception?
No, it is a safety valve.
The limit protects the remaining investors from the buildings being sold off at any price. The deception would be a promise that this could never happen: a fund's liquidity cannot be higher than the liquidity of its worst asset.
In short
Funds that buy up companies work on promises: the investors sign a paper and pay the money in parts, when they are called. The manager takes a fee every year and a share of the profit, but only after returning to people what they put in. In its first years such a fund is almost always in the red, and that is normal. The pretty percentage return in its report is easy to dress up, so what you have to look at is how much real money has already come back. And if a fund owns buildings and promises payouts every month, remember: a building cannot be sold quickly, and one day the payouts will be limited.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.