Introduction to Private Equity Fund Terms (2022)

Let’s look at each of these in turn.

Fund Structure

The most common form of business organization used by private equity funds in the United States and most other parts of the world is the limited partnership. In a limited partnership, at least one partner—called the general partner—is responsible for managing the business of the partnership, while the other partners—called limited partners—are merely investors with no responsibility for managing the business of the partnership. In fact, to preserve their limited liability (similar to shareholders in a corporation), the limited partners are actually not allowed to manage the business of the partnership. The general partner is, however, personally liable for the debts and obligations of the limited partnership, as a consequence of being the partner responsible for managing the business of the partnership.

In the case of a private equity or venture capital fund, investors—called limited partners—subscribe for limited partnership interests in the fund. The fund sponsor—called the general partner—is then responsible for sourcing, evaluating, making, and managing investments for the fund. When the fund sells one of its investments, the investors receive distributions from the sale proceeds, and the fund sponsor may receive distributions from the sale proceeds if the proceeds exceed a certain threshold. (Bear with me, we’ll get to the distribution waterfall, as it is called in private equity and venture capital, in a bit.)

This relationship among the investors and the fund sponsor is governed by a combination of partnership law in the state or country where the limited partnership is established and a limited partnership agreement, often abbreviated LPA, entered into among the investors and the fund sponsor.

Why did the private equity industry settle on the limited partnership as the standard form for private equity funds? There were several reasons.

(Video) Introduction to Private Equity Funds with Simpson Thacher

The most obvious was the pass-through nature of the limited partnership for US federal income tax purposes. (Non-US investors may know this by the terms “fiscally-transparent”, “tax transparent”, or “flow-through”.) The limited partnership does not pay taxes upon the income, capital gains, expenses, or capital losses from its investments. Instead, the income, capital gains, expenses or capital losses are divided among the partners in proportion to their limited partnership interests and the partners are separately responsible for recording these amounts on their income tax returns and paying taxes on these amounts. For investors, this sidesteps—at the expense of creating other complications for foreign and tax-exempt investors (a lengthy and complicated topic that we won’t discuss here)—the issue of double taxation on the same item of income or capital gain. (By way of illustration, consider a corporation that receives income of $10 million from investments it made in other corporations. This corporation would pay corporate income tax on this $10 million, at approximately 35%. When the corporation distributes the net proceeds of $6.5 million by way of dividends, its shareholders would pay income taxes on the dividends they receive. In the case of a limited partnership, the $10 million in investment income would be taxed once, when it is distributed to the partners.)

The second reason for choosing the limited partnership is the flexibility of the limited partnership. The partnership laws of most states and countries tend to be flexible default rules that the partners can override in their limited partnership agreements. This allows the fund sponsor and investors to tailor their agreement to fit their needs.

Restrictions

The limited partnership agreement will impose certain restrictions on investors and fund sponsors. The reasons for having restrictions on the fund sponsor are fairly obvious, but why are there restrictions on investors?

Well, a lot of that has to do with some of my favorite topics (no, not really, do I look crazy): United States securities laws, bank holding company laws, and employee benefit plan laws. These are highly complex topics, and definitely beyond the scope of this introduction. If you are thinking of starting a fund, my advice would be to find a very good funds lawyer with experience forming private equity or venture capital funds. He will be worth his weight in gold when you’re up to your eyeballs in these issues (and you will be up to your eyeballs in these issues at the start of fundraising).

One further restriction that fund sponsors impose on investors is a minimum investment size. This restriction helps the fund avoid being classified as a “publicly traded partnership” for US federal income tax purposes, and also reduces the administrative burden of dealing with too many investors.

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Investors, in turn, will seek to impose a range of restrictions on the fund sponsor. First, investors will seek to prevent the fund from either exceeding a maximum fund size (the “hard cap”) or falling below a minimum fund size. The professional investors at the fund sponsor will have developed expertise in making investments of a particular size, known as the “bite size”. The maximum fund size will usually be a function of roughly how many investments the fund is expected to make during its investment period and the typical “bite size” that the fund sponsor has expertise in making. This ensures that the fund does not grow so large that the fund sponsor is either forced to target investments that are significantly larger than the “bite size” they have historically taken, or is forced to make significantly more investments than they have historically made.

Second, investors will impose a range of investment limitations on the fund sponsor. These include limits on the maximum size of an investment in any portfolio company, typically expressed as a percentage of the fund size, e.g. 20%. This limit serves to manage the “concentration risk”, i.e. the risk that the firm invests too much of its capital into a single portfolio company.

Third, investors will often specify geographic, sectoral, or asset limitations. These limitations help ensure that the fund sponsor stays within its area of investment expertise.

Fourth, investors will limit the ability of the fund sponsor to raise debt financing. This is less common in real estate funds, where there are often fairly generous provisions permitting the use of some amount of leverage and guarantees of the debt of portfolio projects.

Fifth, if the fund sponsor has already raised other private equity or venture capital funds (which we shall call “predecessor funds”, investors will seek to limit the fund’s ability to co-invest alongside or acquire portfolio companies from such predecessor funds. This limits the ability a fund sponsor to have a new fund “rescue” an investment made by an older fund.

(Video) Introduction to Private Equity

Sixth, investors will limit the ability of the fund to reinvest the proceeds from successful exits. These limits are very carefully crafted, and can include requirements that the exit have happened within a short period of time from the date of the original investment, limits on the amount (typically only the amount of the original capital contributed) that can be reinvested, or a fixed time limit after which such reinvestments are no longer permitted.

Seventh, investors will limit the period of time during which the fund sponsor can call capital to make investments, the “investment period”. This is typically a period of around five years (in more aggressive markets like China this can sometimes be as short as three years). After the investment period ends, the fund may no longer call capital from the investors to make new investments.

Alignment of Interest

The relationship between investors and the private equity or venture capital fund sponsor inevitably create an agency problem; the fund sponsor is empowered to make investment decisions on behalf of the private equity or venture capital fund, but the capital at risk from those decisions is that of the investors. Furthermore, there is information asymmetry as the fund sponsor has more information regarding the investment decisions and day-to-day operations of the fund than the investors.

To overcome the agency problem, investors will demand certain terms that act to—in theory—align the interests of investors and fund sponsor.

The first such term is the general partner’s (or fund sponsor’s) contribution. The general partner’s contribution is a limited partnership investment of between 1 — 5% of the total fund. This ensures that the fund sponsor has “skin in the game” and will suffer a loss of capital (alongside the investors) if the fund fails to perform well enough to return all the contributed capital.

(Video) Introduction To Private Equity & Venture Capital #1: Ecosystem & Industry Dynamics

The second term is more controversial. By convention, private equity and venture capital fund sponsors are compensated for managing the fund in accordance with the 2 and 20 rule. The fund sponsor typically receives a management fee of 2% per annum (calculated on the basis of the total fund size during the investment period, and thereafter calculated on the basis of the amount the fund has invested and not yet divested). This management fee can vary: some venture capital funds have received management fees of around 2.5%, while some larger buyout funds may charge only 1.5% (but on a fund size that can easily reach a few billion dollars).

It also receives a performance fee, known as “carried interest”, of approximately 20%, if the fund manages to achieve certain performance targets.

The 2 and 20 rule is a bit of a historical accident; to the best of my knowledge there are no rational principles underpinning it. It just happens to be the terms that were agreed in the early venture capital industry in the 1960s, and which have since become the accepted norm in the industry.

Conclusion

This post has become almost as long as some of the contracts I negotiated in my old job. Let’s end this post here, with a recap. Private equity and venture capital funds are typically governed by a limited partnership agreement. Because of the agent-principal problem, the investors will generally seek to impose certain restrictions on the fund sponsor’s ability to take certain actions that might be detrimental to the investors’ interests, and require certain steps to be taken to, in theory, align the interest of the fund sponsor and the investors. These terms can be quite heavily negotiated, but there are certain industry norms that have developed over the years and which are generally accepted by both fund sponsors and investors.

FAQs

What is a private equity fund in simple terms? ›

Private equity describes investment partnerships that buy and manage companies before selling them. Private equity firms operate these investment funds on behalf of institutional and accredited investors.

What is a typical term of a private equity fund? ›

Private equity firms will typically look to hold investments for between four and seven years, at which time they will look to sell, or 'exit', their stake, either on the stock market, to a corporate buyer or to another investor.

What are the stages of a private equity fund? ›

According to Blackstone's Private Wealth Solutions group, the life cycle of PE funds is typically 7 to 10 years, and is generally broken down into three stages: the fundraising period, the investment period, and the harvest period.

What are the three types of private equity funds? ›

There are three key types of private equity strategies: venture capital, growth equity, and buyouts.
...
3 Types of Private Equity Strategies
  • Venture Capital. Venture capital (VC) is a type of private equity investment made in an early-stage startup. ...
  • Growth Equity. ...
  • Buyouts.
13 Jul 2021

How does a PE fund work? ›

Similar to a mutual fund or hedge fund, a private equity fund is a pooled investment vehicle where the adviser pools together the money invested in the fund by all the investors and uses that money to make investments on behalf of the fund.

Who invests in PE funds? ›

Firms generally require a minimum investment of $200,000 or more, which means private equity is geared toward institutional investors or those who have a lot of money at their disposal.

What is a term sheet in PE? ›

What is a term sheet in private equity? In the context of private equity, a term sheet is defined as a non-binding contract that a private equity provider involves with a target company. Thus, it requires investment to raise capital to take its business venture forward.

What is it called when a private equity fund ends? ›

Harvesting. Once the Investment period has expired, the fund will be finished with making initial investments, and will focus on helping the portfolio companies grow and succeed and on exiting its investments.

What is fund life cycle? ›

A lifecycle fund is an all-in-one investment option that offers you, in a single fund, a diversified portfolio with an asset allocation geared to the year in which you expect to retire. Most lifecycle funds invest in other mutual funds, which is known as a "fund of funds" strategy.

What is the J curve in private equity? ›

The J-Curve in Private Equity

The term J-curve is used to describe the typical trajectory of investments made by a private equity firm. The J-curve is a visual representation of the plain fact that sometimes things will get worse before they get better.

What is GP and LP in private equity? ›

A private equity firm is called a general partner (GP) and its investors that commit capital are called limited partners (LPs). Limited partners generally consist of pension funds, institutional accounts and wealthy individuals.

How do private equities work? ›

Private equity operates with investors and uses funds to invest in private companies or buy out public companies. By doing so, general partners can obtain control over management and other operational changes to increase profitability in hopes to later sell at a successful rate.

What are the 5 types of private equity? ›

What are the different types of private equity investments?
  • Venture capital (VC). VC firms are a type of private equity company that typically invest in start-ups and early-stage companies anticipated to grow. ...
  • Buyouts. ...
  • Growth Equity. ...
  • Real estate. ...
  • Fund of funds.

How many types of PE are there? ›

Types of Private Equity Funds

Private equity funds generally fall into two categories: Venture Capital and Buyout or Leveraged Buyout.

What is private equity and its types? ›

Private equity (PE) is money invested into companies that are not publicly traded. Public companies are companies that have equity structured as shares of stock. These companies are traded on a stock exchange after an initial public offering (IPO).

How do private equity funds raise money? ›

Private equity firms raise money from institutional investors (e.g. pension funds, insurance companies, sovereign wealth funds and family offices) for the purpose of investing in private businesses, growing them and selling them years later, generating better returns for investors than they can reliably get from public ...

How long does a private equity fund last? ›

This period also generally lasts 4-6 years. The fund will exit investments and distribute profits among the investors (and carryholders). Sometimes there are follow on investments during this period. At the end of the life of a fund, remaining investments are liquidated.

What is the difference between equity and private equity? ›

To go back to first principles, equity is a stake of a company's value. Public equity is a share in a company that is publicly traded on a stock exchange. Private equity is a stake in any company that is not publicly traded.

What is the minimum investment for private equity? ›

The minimum investment in private equity funds is relatively high—typically $25 million, although some are as low as $250,000. Investors should plan to hold their private equity investment for at least 10 years.

What is difference between hedge fund and private equity? ›

Hedge funds are alternative investments that use pooled money and a variety of tactics to earn returns for their investors. Private equity funds invest directly in companies, by either purchasing private firms or buying a controlling interest in publicly traded companies.

Why do people go into private equity? ›

Investors seek out private equity (PE) funds to earn returns that are better than what can be achieved in public equity markets. But there may be a few things you don't understand about the industry. Read on to find out more about private equity (PE), including how it creates value and some of its key strategies.

What are 5 key points of a term sheet? ›

But no matter who the investor is, a term sheet will always contain six key components, including:
  • A valuation. An estimate of what a company is worth as an investment opportunity. ...
  • Securities being issued. ...
  • Board rights. ...
  • Investor protections. ...
  • Dealing with shares. ...
  • Miscellaneous provisions.
15 Apr 2019

What are VC terms? ›

The VC Term Sheet establishes the specific conditions and agreements of venture investments between an early-stage company and venture firm. The term sheet is short, usually less than 10 pages, and is prepared by the investor.

What is the difference between an LOI and term sheet? ›

The main difference between the two is that a term sheet is simply a document that lays out the terms that both parties wish to include, and usually neither party will sign the document. The letter of intent, on the other hand, includes those terms but is singed by both parties involved.

What is a good IRR for private equity? ›

What is a Good IRR For an Investment? Most venture capital firms aim for an IRR of 20% or higher. However, it's important to consider the length of a project when evaluating an IRR. Longer-term projects could result in more returns, even if the IRR is lower.

What is a good IRR? ›

Typically speaking, a higher IRR means a higher return on investment. In the world of commercial real estate, for example, an IRR of 20% would be considered good, but it's important to remember that it's always related to the cost of capital.

How long do PE firms hold companies? ›

Private equity investments are traditionally long-term investments with typical holding periods ranging between three and five years. Within this defined time period, the fund manager focuses on increasing the value of the portfolio company in order to sell it at a profit and distribute the proceeds to investors.

What is the harvest period in private equity? ›

Harvest Period — Capital Distributions

Existing portfolio company investments typically begin to be exited three to five years after the original investment, the harvest period, generating distributions that flow back to investors.

What are the two types of life cycle funds? ›

Targeted Date - Investment funds are designed to grow steadily for a set timeframe, usually until retirement. Declining Risk - Investment funds shift from riskier growth-oriented options to more conservative income producing options as your target date approaches.

What are the four phases of the investor's life cycle? ›

Government's investment life cycle is made up of four phases: think, plan, do and review. A business case turns an idea (think) into a proposal (plan).

What is the difference between J-curve and S curve? ›

Two types of population growth patterns may occur depending on specific environmental conditions: An exponential growth pattern (J curve) occurs in an ideal, unlimited environment. A logistic growth pattern (S curve) occurs when environmental pressures slow the rate of growth.

What is blind pool risk? ›

A blind pool, also known as "blank check underwriting" or a "blank check offering," is a direct participation program or limited partnership that lacks a stated investment goal for the funds that are raised from investors.

What is AJ curve theory? ›

The J Curve is an economic theory that says the trade deficit will initially worsen after currency depreciation. The nominal trade deficit initially grows after a devaluation, as prices of exports rise before quantities can adjust.

What is a waterfall in private equity? ›

Private equity waterfall models are a method of dividing the capital gain or investment returns across all investors. Waterfall structures allow LPs to provide the GP or fund manager with financial incentives intended to motivate them to achieve even bigger returns.

How many LPs can a fund have? ›

Recently, the SEC changed regulations regarding the number of investors funds below $10m can have and increased the number to 250 limited partners.

Why are PE firms called sponsors? ›

A private equity fund is managed by a private equity firm, often called a private equity sponsor or financial sponsor. The fund is the investment or capital used to buy a controlling interest in a private company, while the sponsor is responsible for operating the fund.

What is fund structure? ›

A fund structure determines a fund's asset investment and associated administrative fees. Fund structures are selected to match the envisioned life of the fund and the frequency of distributions. See various fund structure options below.

What happens when private equity buys a company? ›

Private equity firms invest money in mature businesses in traditional industries in exchange for an ownership stake – also called equity – in that company. Private equity firms invest in businesses with the goal of increasing the value of the business over time and eventually selling that business.

What is the largest private equity firm? ›

KKR took over the top spot as the top private equity firm in the world in 2022. As of the end of June, KKR has $491 billion in assets under management, or AUM, and holds a total of 121 companies in its private equity funds. Those companies generate a total of about $223 billion in annual revenues.

What is unique about private equity? ›

Unlike public markets, a private market investor can have information advantages, such as access to management and greater visibility into a potential portfolio company. Private equity is an inefficient market compared to public markets, and thus provides additional opportunities for attractive valuations.

Is there a private equity ETF? ›

Private equity exchange-traded funds (ETFs) hold companies that can be financially complicated because they use leverage and are strongly transaction-oriented. However, they provide investors with exposure to private equity investments and can offer significant and attractive returns on investment.

What is the difference between growth equity and private equity? ›

The following are among the most significant contrasts between growth equity and private equity: Level of investment: Growth equity is distinct from traditional private equity in that it invests much more money. PE firms often buy whole businesses instead of the majority holdings held by growth equity firms.

What is dry powder in private equity? ›

At venture capital and private equity firms, “dry powder” is cash that's been committed by investors but has yet to be “called” by investment managers in order to be allocated to a specific investment.

What is PE buyout? ›

A buyout is the process whereby a management team, which may be the existing team or one assembled specifically for the purpose of the buyout, acquires a business (Target) from the current owners of Target using equity finance from a private equity provider and debt finance from financial institutions.

What is private equity in simple terms? ›

Private equity, in a nutshell, is the investment of equity capital in private companies. In a typical private equity deal, an investor buys a stake in a private company with the hope of ultimately realising an increase in the value of that stake.

What is the difference between private equity and mutual fund? ›

PE funds typically invest in private companies whereas mutual funds typically invest in publicly-traded companies. And mutual funds are only allowed to collect management fees, whereas PE funds can collect performance fees, discussed in more depth below.

What is the difference between a hedge fund and private equity? ›

Hedge funds are alternative investments that use pooled money and a variety of tactics to earn returns for their investors. Private equity funds invest directly in companies, by either purchasing private firms or buying a controlling interest in publicly traded companies.

What is the difference between PE and VC? ›

Private equity is capital invested in a company or other entity that is not publicly listed or traded. Venture capital is funding given to startups or other young businesses that show potential for long-term growth.

Why do people go into private equity? ›

Investors seek out private equity (PE) funds to earn returns that are better than what can be achieved in public equity markets. But there may be a few things you don't understand about the industry. Read on to find out more about private equity (PE), including how it creates value and some of its key strategies.

Who owns private equity firms? ›

Private equity firms are, as their name suggests, private — meaning they're owned by their founders, managers, or a limited group of investors — and not public — as in traded on the stock market.

How do private equity funds raise money? ›

Private equity firms raise money from institutional investors (e.g. pension funds, insurance companies, sovereign wealth funds and family offices) for the purpose of investing in private businesses, growing them and selling them years later, generating better returns for investors than they can reliably get from public ...

Is hedge fund a private fund? ›

Hedge funds are private funds that pool investors' money and invest in a wide range of assets.

How many PE funds are there? ›

There are more than 18,000 PE funds – a nearly 60% increase in just the last five years. PE currently has $4.4 trillion in assets under management, including $1 trillion of uninvested capital. The size of these funds has more than doubled since 2016.

Who makes more money PE or hedge fund? ›

Hedge fund compensation is more variable than private equity salaries + bonuses, but at the junior levels, you'll most likely earn a bit more in private equity. At the top levels, a star hedge fund PM who has a great year could easily earn more than an MD in private equity – depending on the fund size and structure.

Are private equity funds liquid? ›

Private equity is an illiquid asset class; investors cannot sell their funds when they want to without potentially facing high losses. However, unlike other illiquid asset classes, private equity is a distributing asset - a cash-flow based asset class that generates liquidity when the underlying investments are sold.

What percentage do VC take? ›

What Percentage of a Company Do Venture Capitalists Take? Depending on the stage of the company, its prospects, how much is being invested, and the relationship between the investors and the founders, VCs will typically take between 25 and 50% of a new company's ownership.

How long does private equity hold companies? ›

Private equity investments are traditionally long-term investments with typical holding periods ranging between three and five years. Within this defined time period, the fund manager focuses on increasing the value of the portfolio company in order to sell it at a profit and distribute the proceeds to investors.

What do you do in private equity? ›

Private equity operates with investors and uses funds to invest in private companies or buy out public companies. By doing so, general partners can obtain control over management and other operational changes to increase profitability in hopes to later sell at a successful rate.

Do you need MBA for private equity? ›

Although most large private equity firms look exclusively for job candidates with an MBA, you can still get into a smaller firm without one. Smaller firms prefer candidates with an MBA, but it's not always a requirement.

Videos

1. Private Equity Explained in 2 Minutes in Basic English
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2. The BEST Beginner's Guide to Hedge Funds, Private Equity, and Venture Capital!
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3. Link'n Learn - Introduction to Private Equity - Deloitte Luxembourg
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4. EXPLAIN Private Equity in Simple Terms!
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5. Introduction to Private Equity PE
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6. Introduction To Private Equity & Venture Capital #2: The Nuts And Bolts of PE & VC Funds
(Professor Claudia Zeisberger)

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