Private equity funds are closed-end investment vehicles, which means that there is a limited window to raise funds and once this window has expired no further funds can be raised. These funds are generally formed as either a Limited Partnership (“LP”) or Limited Liability Company (“LLC”). The advantages of these structures for a private equity fund are as follows:
1) Perhaps the biggest advantage for investors is that they are exposed to limited liability. If anything goes wrong in the investment process (bankruptcy, lawsuits, etc.), the investor risks only the capital they have committed.
2) LPs and LLCs are pass-through entities for federal income tax purposes.
Illustrated Organizational Chart:
Raising a private equity fund requires two groups of people:
1) Financial Sponsor (“Sponsor” in image): The team of individuals that will identify, execute and manage investments in privately-held operating businesses. This is generally comprised of a General Partner and a Management Company.
General Partner: The entity with the legal authority to make decisions for the fund. This entity also assumes all legal liability.
Management Company: The operating entity that employs the investment professionals responsible for allocating capital and managing investments.
2) Investors: The individuals that will provide the capital to make those investments. Because funds are generally formed as Limited Partnerships, investors are often referred to as limited partners.
In raising a fund, the fund founders will reach out to sources of institutional capital such as pension plans and university endowments, as well as high net worth family offices and individuals. The commitment to the fund, known as the “capital commitment,” will be made via a partnership agreement stipulating that the capital invested or resulting assets will be returned within a fixed period of time (typically 10 years). In most cases this is structured as a limited partnership agreement (LPA). The LPA will typically include the following:
Mandate: The partnership agreement may provide parameters for acceptable investments. These restrictions could relate to scale, geography and security type, etc.
Fund Term: This defines the time horizons available for investment and divestment.
Management Fees: This defines the fee tied to the capital raised, or assets under management (“AUM”). The Management Company will typically earn an annual 2% fee on AUM.
Distribution Waterfall: Distribution waterfalls define the economic relationship between the general partner (“GP”) and limited partners (“LP”). This is how the GP earns what is known as a carried interest, which is typically 20% of the proceeds after the LP has received distributions equal to the original capital invested plus a defined preferred return. Please follow this link for an example.
Introduction to Private Equity Series:
Part 1: PE Defined | 3-Statement Model vs LBO | Benefits of Leverage
Part 2: How Leverage Can Create and Destroy Value
Part 3: How to Determine the Appropriate Amount of Leverage
Part 4: PE Participants | Independent Sponsor | PE Fund
For more information about private equity please see ASM’s private equity training course.
FAQs
Private equity fund structure
The fund is managed by a private equity firm that serves as the 'General Partner' of the fund. By contributing capital, investors become 'Limited Partners' of the fund. As such, the fund is structured as a 'Limited Partnership'.
What is the structure of a private equity fund? ›
Private equity funds are closed-end investment vehicles, which means that there is a limited window to raise funds and once this window has expired no further funds can be raised. These funds are generally formed as either a Limited Partnership (“LP”) or Limited Liability Company (“LLC”).
What is the 80 20 split in private equity? ›
This means the fund manager receives the next distributions until it has caught up its percentage of carried interest. So, if this were 20%, the fund manager takes distributions until profits are split 20% to the fund manager and 80% to the investors.
What is the most typical organizational structure of a private equity investment? ›
Private equity funds are usually established as a Limited Liability Company (LLC) or a Limited Partnership (LP). The reason the fund is its own entity is the fact that it offers benefits for those involved in these limited partnerships.
What is the 2 20 structure in private equity? ›
This is also known as the “2 and 20” fee structure and it's a common fee arrangement in private equity funds. It means that the GP's management fee is 2% of the investment and the incentive fee is 20% of the profits. Both components of the GPs fees are clearly detailed in the partnership's investment agreement.
What are the 4 main areas within private equity? ›
Equity can be further subdivided into four components: shareholder loans, preferred shares, CCPPO shares, and ordinary shares. Typically, the equity proportion accounts for 30% to 40% of funding in a buyout. Private equity firms tend to invest in the equity stake with an exit plan of 4 to 7 years.
What is a private equity fund in simple terms? ›
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.
What are the three types of private equity funds? ›
3 Types of Private Equity Strategies. There are three key types of private equity strategies: venture capital, growth equity, and buyouts.
What is the life cycle of a PE fund? ›
The life cycle of a typical private equity fund is usually ten years, but that ten years generally doesn't start until the team raises substantial capital and it doesn't end until all assets are sold. So, the life cycle of a private equity fund may stretch to as long as 15 years.
What are the key characteristics of private equity firms? ›
Primary among these characteristics are high risk, illiquidity, and finite durations. Private equity shares can be acquired directly from an issuing company, though because they have high risk and are not liquid, it is more common to acquire private equity through funds for diversification and professional management.
Deal structures can vary depending on the needs and goals of the parties involved. Leveraged buyouts, venture capital deals, mezzanine financing, and management buyouts are common deal structures in private equity. Negotiating and drafting a comprehensive purchase agreement is essential for a smooth transaction.
What is an example of a private equity deal structure? ›
A private equity deal structure example of this is when a company dealing with home appliances is willing to expand its business and has a 100,000-dollar cash flow every year. The company can be liable to get a loan of 180,000 dollars to support its development after being leveraged to its annual earnings.
How do private equity firms structure deals? ›
How is a private equity deal structured? Private equity deals are structured to ensure that the General Partner (GP) has paid a price which enables them to generate the required returns through a combination of financial, operational, and strategic decisions.
