What Is the Structure of a Private Equity Fund? (2022)

Although the history of modern private equity investments goes back to the beginning of the last century, they didn't really gain prominence until the 1980s. That's around the time when technology in the United States got a much-needed boost from venture capital.

Many fledgling and struggling companies were able to raise funds from private sources rather than going to the public market. Some of the big names we know today—Apple, for example—were able to put their names on the map because of the funds they received from private equity.

Even though these funds promise investors big returns, they may not be readily available for the average investor. 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.

If that happens to be you and you're able to make that initial minimum requirement, you've cleared the first hurdle. But before you make that investment in a private equity fund, you should have a good grasp of these funds' typical structures.

Key Takeaways

  • Private equity funds are closed-end funds that are not listed on public exchanges.
  • Their fees include both management and performance fees.
  • Private equity fund partners are called general partners, and investors or limited partners.
  • The limited partnership agreement outlines the amount of risk each party takes along with the duration of the fund.
  • Limited partners are liable for up to the full amount of money they invest, while general partners are fully liable to the market.
(Video) Private Equity Fund Structure

Private Equity Fund Basics

Private equityfunds are closed-end funds that are considered an alternative investment class. Because they are private, their capital is not listed on a public exchange. These funds allow high-net-worth individuals and a variety of institutions to directly invest in and acquire equity ownership in companies.

Funds may consider purchasing stakes in private firms or public companies with the intention of de-listing the latter from public stock exchanges to take them private. After a certain period of time, the private equity fund generally divests its holdings through a number of options, including initial public offering (IPOs) or sales to other private equity firms.

Although minimum investments vary for each fund, the structure of private equity funds historically follows a similar framework that includes classes of fund partners, management fees, investment horizons, and other key factors laid out in a limited partnership agreement (LPA).

For the most part, private equity funds have been regulated much less than other assets in the market. That's because high-net worth investors are considered to be better equipped to sustain losses than average investors. But following the 2008 financial crisis, the government has looked at private equity with far more scrutiny than before.

Fees

If you're familiar with the fee structure of a hedge fund, you'll notice it's very similar to that of a private equity fund. It charges both a management and a performance fee.

The management fee is about 2% of the capital committed to invest in the fund. So a fund with assets under management (AUM) of $1 billion charges a management fee of $20 million. This fee covers the fund's operational and administrative fees such as salaries, deal fees—basically anything needed to run the fund. As with any fund, the management fee is charged even if it doesn't generate a positive return.

The performance fee, on the other hand, is a percentage of the profits generated by the fund that are passed on to the general partner (GP). These fees, which can be as high as 20%, are normally contingent on the fund providing a positive return. The rationale behind performance fees is that they help bring the interests of both investors and the fund manager in line. If the fund manager is able to do that successfully, they are able to justify their performance fee.

Partners and Responsibilities

Private equity funds can engage in leveraged buyouts (LBOs),mezzanine debt,private placementloans,distressed debt,or serve in the portfolio ofafund of funds. While many different opportunities exist for investors, these funds are most commonly designed as limited partnerships.

(Video) How To Start A Private Equity Fund From Scratch

Those who want to better understand the structure of a private equity fund should recognize two classifications of fund participation. First, the private equity fund’s partners are known as general partners. Under the structure of each fund, GPs are given the right to manage the private equity fund and to pick which investments they will include in their portfolios. GPs are also responsible for attaining capital commitments from investors known as limited partners (LPs). This class of investors typically includes institutions—pension funds, university endowments, insurance companies—and high-net-worth individuals.

Limited partners have no influence over investment decisions. At the time that capital is raised, the exact investments included in the fund are unknown. However, LPs can decide to provide no additional investment to the fund if they become dissatisfied with the fund or the portfolio manager.

Limited Partnership Agreement

When a fund raises money, institutional and individual investors agree to specific investment terms presented in alimited partnership agreement. What separates each classification of partners in this agreement is the risk to each. LPs are liable for up to the full amount of money they invest in the fund. However, GPs are fully liable to the market, meaning if the fund loses everything and its account turns negative, GPs are responsible for any debts or obligations the fund owes.

The LPA also outlines an important life cycle metric known as the “Duration of the Fund.” PE funds traditionally have a finite length of 10 years, consisting of five different stages:

  • The organization and formation.
  • The fund-raising period. This period typically lasts about 12 months.
  • The period of deal-sourcing and investing.
  • The period of portfolio management, about five years with a possible on-year extension.
  • The exiting from existing investments through IPOs, secondary markets, or trade sales.

Private equity funds typically exit each deal within a finite time period due to the incentive structure and a GP's possible desire to raise a new fund. However, that time frame can be affected by negative market conditions, such as periods when various exit options, such as IPOs, may not attract the desired capital to sell a company.

One of the most lucrative PE exits in 2020 came from Providence Equity's sale of their stake in Zenimax Media, the parent company of Bethesda Softworks, a game developer. The firm sold its stake, which it acquired in 2007, to Microsoft for $7.5 billion, not bad considering their initial investment was just $300 million.

(Video) Private equity explained

Investment and Payout Structure

Perhaps the most important components of any fund’s LPA are obvious: The return on investment and the costs of doing business with the fund. In addition to the decision rights, the GPs receive a management fee and a “carry.”

The LPA traditionally outlines management fees for general partners of the fund. It's common for private equity funds to require an annual fee of 2% of capital invested to pay for firm salaries, deal sourcing and legal services, data and research costs, marketing, and additional fixed and variable costs. For example, if a private equity firm raised a $500 million fund, it would collect $10 million each year to pay expenses. Over the duration of the 10-year fund cycle, the PE firm collects $100 million in fees, meaning $400 million is actually invested during that decade.

Private equity companies also receive a carry, which is a performance fee that is traditionally 20% of excess gross profits for the fund. Investors are usually willing to pay these fees due to the fund's ability to help manage and mitigate corporate governance and management issues that might negatively affect a public company.

Other Considerations

The LPA also includes restrictions imposed on GPs regarding the types of investment they may be able to consider. These restrictions can include industry type, company size, diversification requirements, and the location of potential acquisition targets.In addition, GPs are only allowed to allocate a specific amount of money from the fund into each deal they finance. Under these terms, the fund must borrow the rest of its capital from banks that may lend at different multiples of a cash flow, which can test the profitability of potential deals.

The ability to limit potential funding to a specific deal is important to limited partners because holding several investments bundled together improves the incentive structure for the GPs. Investing in multiple companies provides risk to the GPs and could reduce the potential carry, should a past or future deal underperform or turn negative.

Meanwhile, LPs are not provided with veto rights over individual investments. This is important because LPs, which outnumber GPs in the fund, would commonly object to certain investments due to governance concerns, particularly in the early stages of identifying and funding companies. Multiple vetoes of companies may reduce the positive incentives created by the commingling of fund investments.

(Video) What REALLY is Private Equity? What do Private Equity Firms ACTUALLY do?

The Bottom Line

Private-equity firms offer unique investment opportunities to high-net-worth and institutional investors. But anyone who wants to invest in a PE fund must first understand their structure so they are aware of the amount of time they will be required to invest, all associated management and performance fees, and the liabilities associated.

Typically, PE funds have a10-year duration, require 2% annual management fees and 20% performance fees, and require LPs to assume liability for their individual investment, while GPs maintain complete liability.

FAQs

What is private equity fund structure? ›

Private equity funds are closed-end funds that are considered an alternative investment class. Because they are private, their capital is not listed on a public exchange. These funds allow high-net-worth individuals and a variety of institutions to directly invest in and acquire equity ownership in companies.

What is the structure of a fund? ›

A stand-alone fund structure comprises three entities: 1) the fund (the entity holding the securities through which the investors participate), 2) the general partner of the fund (the company responsible for the day-to-day operations of the fund) and 3) the investment manager of the fund (the company responsible for ...

What is the most typical organizational structure of a private equity investment? ›

Most private equity funds are organized as limited partnerships or limited liability companies and have a finite life (usually 10 years). A fund goes through a number of overlapping stages: Organization/Formation (Year 0) Fund Raising (Years 0 to 2)

How do private equity fund of funds work? ›

What is a Private Equity Fund of Funds? A private equity fund of funds acts as a Limited Partner for private equity firms. It raises capital from institutional investors such as pensions, sovereign wealth funds, endowments, and high-net-worth individuals, and it invests that capital in specific PE firms.

What is private equity in simple terms? ›

Private equity refers to the debts and shares of companies that are not publicly traded on a stock exchange. The term may also refer to venture capital that is invested in newly started businesses, known as startups.

What is the most likely type of legal structure for a private equity fund? ›

Most venture and private equity funds use a limited partnership as their legal structure (Figure 2), which involves two main types of actors: (1) a general partner (GP) and (2) limited partners (LPs).

How do private equity investors make money? ›

Key Takeaways

Private equity is an alternative investment class that invests in or acquires private companies that are not listed on a public stock exchange. Private equity firms earn money by charging management and performance fees from investors in a fund.

What is the lifecycle of private equity funds? ›

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 is investment structure? ›

An investment structure refers to the way your investments are legally owned. Many people simply purchase assets in their own name or joint names, when other ownership structures may be more suitable.

What is the main business model of a typical private equity firm? ›

The business model of a private equity firm is as follows – raise capital from external sources, invest the capital in a se- ries of private equity deals, sell (or “exit”) those investments (often many years later), and return the proceeds from these exits to the external capital partners while holding back 20 percent ...

What happens at the end of a private equity fund? ›

At the end of the life of a fund, remaining investments are liquidated. Proceeds are distributed. Limited extensions to fund term possible – usually 2 years at the discretion of the GP and then longer if a majority of investors wish it.

What is the role of private equity firms? ›

The purpose of private equity firms is to provide the investors with profit, usually within 4-7 years. It comprises companies or investment managers that acquire capital from wealthy investors to invest in existing or new companies.

What is private equity with example? ›

Private equity is the category of capital investments made into private companies. These companies aren't listed on a public exchange, such as the New York Stock Exchange. As such, investing in them is considered an alternative.

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.

How long does a private equity fund last? ›

Private equity funds are typically limited partnerships with a fixed term of 10 years (often with annual extensions).

Why do people invest in private equity? ›

Unlike direct investments in non-listed companies, you leave it to the Private Equity fund to create value. Private Equity is a key catalyst for economic development. It boosts corporate growth and job creations and helps new generations of business leaders emerge.

Why do people go into private equity? ›

You prefer PE because it's a blend of both operations and finance and because you can help Founders with well-established businesses make them even better via solid analysis and research rather than just guesswork.

What do you call someone who works in private equity? ›

Private Equity Analysts are hired directly out of undergrad without previous full-time experience. They work on the same types of tasks as Associates: deal sourcing, reviewing potential investments, monitoring portfolio companies, and fundraising, but they complete fewer projects independently from start to finish.

What asset classes are in private equity? ›

How do you define private equity as an asset class? Private equity refers to investing in a company that does not have a publicly listed security. The asset class comprises a spectrum of investment opportunities, from startups needing seed capital to mature, cash flow-producing companies.

What is an umbrella structure? ›

Umbrella Fund. A master-feeder structure allows multiple funds using the same investment strategy to pool their capital and be managed as part of a bigger investment pool. An umbrella fund allows a fund to create compartments such that each sub-fund can provide different investment strategies or rights to investors.

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.

What are the methods of private equity funding? ›

A private equity fund is a collective investment scheme used for making investments in various equities and debt instruments. They are usually managed by a firm or a limited liability partnership. The tenure (Investment horizon) of such funds can be anywhere between 5-10 years with an option of annual extension.

What percentage do private equity firms take? ›

Private equity funds have a similar fee structure to that of hedge funds, typically consisting of a management fee and a performance fee. Private equity firms normally charge annual management fees of around 2% of the committed capital of the fund.

What returns do private equity firms make? ›

Private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020. Between 2000 and 2020, private equity outperformed the Russell 2000, the S&P 500, and venture capital. When compared over other time frames, however, private equity returns can be less impressive.

What is first close in private equity? ›

“final close.” First close basically means that when a certain threshold of money has been raised, the PE firm can begin making investments and actually closing deals and new LPs can still join in by committing capital for a limited time (e.g., 1 year from first close).

What is deal flow in private equity? ›

Deal flow is a term used by finance professionals such as venture capitalists, angel investors, private equity investors and investment bankers to refer to the rate at which they receive business proposals/investment offers.

How long do private equity firms keep companies? ›

Private equity firms' average portfolio company holding periods have historically averaged from four to five years (Strömberg 2008), and a majority of private equity firms use a five-year forecasting period in evaluating investments (Gompers et al. 2016).

How do you structure an investment portfolio? ›

How to build an investment portfolio
  1. Decide how much help you want.
  2. Choose an account that works toward your goals.
  3. Choose your investments based on your risk tolerance.
  4. Determine the best asset allocation for you.
  5. Rebalance your investment portfolio as needed.
17 Aug 2022

What are 4 types of investments? ›

There are four main investment types, or asset classes, that you can choose from, each with distinct characteristics, risks and benefits.
  • Growth investments. ...
  • Shares. ...
  • Property. ...
  • Defensive investments. ...
  • Cash. ...
  • Fixed interest.

What is financial capital structure? ›

Capital structure refers to the specific mix of debt and equity used to finance a company's assets and operations. From a corporate perspective, equity represents a more expensive, permanent source of capital with greater financial flexibility.

What is the minimum corpus required for a PE fund? ›

Funds are not pooled, and investors have separate Demat accounts. A minimum corpus of Rs. 20 crore is required.

What does private equity look for? ›

Their mission is to invest in companies (with a majority or minority stake), create value during a period of approximately four or five years and then sell their share with the greatest capital gain possible. Therefore, they look for businesses that show clear growth potential in sales and profits over the next years.

What is growth capital in private equity? ›

Growth Capital Meaning

So basically, growth capital serves the purpose of facilitating target companies to accelerate growth. Growth capital is placed on the gamut of private equity investing at the crossroads of venture capital and control buyouts. We noted above that Kobalt raised $75 million in growth capital.

What do private equity funds invest in? ›

Private equity (PE) refers to a constellation of investment funds that invest in or acquire private companies that are not listed on a public stock exchange. So-called PE funds may also buy out public companies, take them private, and then restructure them for potential future growth.

How Much Can private equity carry? ›

Carry typically averages about 20% of the fund's profits and ranges from as high as 50% in exceptional cases to as low as in the single digits. With the proliferation of private equity funds, there is increasing downward pressure on carry as fund managers compete with each other to attract investor capital.

How long does it take to raise a private equity fund? ›

Raising a fund can take substantially longer than raising money for a single investment. Depending on interest from investors and the timeline to complete compliance requirements, a sponsor should expect to spend at least six months on a fund, and the process can often take more than a year from concept to close.

Why is it called private equity? ›

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.

Who can invest in private equity? ›

Who can invest? A private equity fund is typically open only to accredited investors and qualified clients. Accredited investors and qualified clients include institutional investors, such as insurance companies, university endowments and pension funds, and high income and net worth individuals.

Where are most private equity firms located? ›

New York is home to the largest number of private equity firms globally, with 445 active firms currently based there, and $633 billion in private equity funds being raised over the past 10 years.

What is private equity and its types? ›

More formally, private equity is a type of equity and one of the asset classes consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange. A private-equity investment will generally be made by a private-equity firm, a venture capital firm or an angel investor.

What happens when private equity buys a company? ›

When a private-equity firm (PE) acquires a company, they work together with management to significantly increase EBITDA during its investment horizon. A good portfolio company can typically increase its EBITDA both organically and by acquisitions.

Are private equity funds regulated? ›

Private funds are not required to be registered or regulated as investment companies under the federal securities laws. A private fund cannot publicly offer its securities.

Is private equity better than public? ›

Generally, public equity investments are safer than private equity. They are also more readily available for all types of investors. Another advantage for public equity is its liquidity, as most publicly traded stocks are available and easily traded daily through public market exchanges.

Is private equity the same as private investment? ›

Most investment groups, from small investment clubs to larger corporate interests, have much lower barriers to entry. Smaller investors who see the potential in a firm can pool their money and buy into the company, while private equity funds buy the entire company in an effort to sell it at a profit at a later date.

Can a private equity firm be public? ›

A private equity firm can either list publicly as a quoted public company, or launch an investment trust.

Why do PE funds have multiple closings? ›

A Fund may hold multiple Investor closings in order to reach the manager's desired aggregate commitment amount. The fundraising period is usually limited to a period of six months to one year from the date of the initial closing in a Closed- End Fund.

When can you sell private equity? ›

Typically, employee shareholders have to wait until their company goes public or gets acquired before they can sell their private stocks. However, some companies offer early access to liquidity through a secondary transaction, such as a tender offer.

Is a private equity fund an investment fund? ›

A private equity fund is also a managed investment fund that pools money, but they normally invest in private, non-publicly traded companies and businesses.

What is private equity with example? ›

Private equity is the category of capital investments made into private companies. These companies aren't listed on a public exchange, such as the New York Stock Exchange. As such, investing in them is considered an alternative.

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

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 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 lifecycle of private equity funds? ›

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 is private equity and its types? ›

More formally, private equity is a type of equity and one of the asset classes consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange. A private-equity investment will generally be made by a private-equity firm, a venture capital firm or an angel investor.

Why is private equity important? ›

The symbiosis between private equity firms, portfolio companies, and limited partners. Private equity (PE) firms play an important role in the economy: They can help small enterprises grow, and, in turn, generate returns for investors.

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.

How much money do you need to start a private equity fund? ›

Another important factor to consider is a firm's minimum investment requirement. Historically, the standard minimum investment amount for private equity has been $25 million.

Who makes more money private equity 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.

Can you make a lot of money in private equity? ›

Managing partners pulled in $1.59 million, on average, at small private equity firms, while partners and managing directors averaged $985,000 in salary and bonuses. For firms with $2 billion to $3.99 billion in assets, top bosses made $2.25 million, and partners and managing directors averaged about $1 million.

How long does a private equity fund last? ›

Private equity funds are typically limited partnerships with a fixed term of 10 years (often with annual extensions).

What is first close in private equity? ›

Initial closing – the first time that investors commit to making their investment in the fund. Final closing – the last investors commit to making their investments. Commitment period – the period over which investors are required to make their commitments, i.e. pay the money over!

What does a private equity company do? ›

The purpose of private equity firms is to provide the investors with profit, usually within 4-7 years. It comprises companies or investment managers that acquire capital from wealthy investors to invest in existing or new companies.

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

The post-commitment period, also commonly referred to as the divestment period, is when the fund manager holds and then liquidates the fund's investments. The liquidation doesn't happen all at once. Rather, there are typically a series of liquidations over the course of several years.

What is deal flow in private equity? ›

Deal flow is a term used by finance professionals such as venture capitalists, angel investors, private equity investors and investment bankers to refer to the rate at which they receive business proposals/investment offers.

What is a closed ended private equity fund? ›

A type of fund that has a fixed number of shares outstanding, which are offered during an initial subscription period, similar to an initial public offering. After the subscription period is closed, the shares are traded on an exchange between investors, like a regular stock.

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