Do you hear the term private equity in financial conversation but need to know its meaning? Private equity is more than just a buzzword. It’s a complex investment world that offers substantial returns to those willing to dig deep and learn its intricacies. This alternative investment is capital that’s not listed on the public exchanges. It’s often used for leveraged buyouts or venture capital funding.
You need to understand the unique fund structure of private equity to grasp its mechanics. The fund structure is crucial to how investments are made and how your clients earn profits. This is not your typical hedge or mutual fund. What you need to understand about private equity fund structure.
How are Private Equity Funds Set Up?
Private equity funds are pools of capital formed by limited partnership agreements (LPs). LPs are the ones who contribute the capital to the fund and have the right to receive (most of) the returns. LPs “commit” funds mechanically but won’t wire the money to the private equity firm until that firm has finalized an investment deal.
Private equity firms invest their capital in shares of private or public companies they intend to delist. They do so in the hope that these companies’ value will increase.
How is a Private Equity Fund structured?
Private equity funds are investment vehicles that pool various investors’ capital, such as pension funds, endowments and high-net-worth individuals. Private equity professional manage the funds and aim to make returns by investing in companies.
This is a typical private equity fund structure:
- 1. Fund Formation
- General partner (GP): An entity that manages a private equity fund and is responsible for investment decisions.
- Limited Partners: Investors that contribute capital to a fund. They have limited control of the fund’s operation but benefit from its profits.
- 2. Fundraising:
GPs can raise capital LPs using a fundraising procedure typically organized in a series. Fundraising involves presenting investment strategies, track records, and potential returns to attract investors.
- 3. Investment period:
The GP invests the capital into the target companies or assets by the fund’s investment strategy. This phase includes due diligence, negotiation, and acquisitions.
- 4. Carry-out and Management Fees
- Management fees: General Partners charge a management fee annually (normally a percentage of the capital committed) to cover operating expenses.
- Carry Interest (Carrying): The GPs receive a portion of the profits (normally 20%) after the LPs have met certain thresholds. The GP’s interests are aligned with those of the LPs.
- 5. Investment Realization
The GP will work to increase the value of acquired companies over a period usually between 4-7 years. They are aiming for a strategy of exit (such as IPO, sale, merger or IPO), which will bring profits to the fund.
- 6. Distributions of Profits
Profits are divided between the GP and the LPs after exits. The GP shares include their capital invested and a portion (the carry) of the profits, which depend on the fund’s performance.
- 7. Liquidation/Wind-up
Once the fund’s investments are divested, and profits are distributed, the fund is liquidated, and any remaining assets or proceeds are distributed to the investors.
- 8. Regulation and Compliance
Private equity funds are subject to regulations that vary by jurisdiction, aiming to protect investors and ensure transparency in operations.
Stages of Private Equity Funds
The life cycle of a private equity fund depends on the liquidity of the assets or companies acquired. The life cycle for funds that invest in real estate is as short as five years. However, those who invest in less liquid companies such as manufacturing or specialized food and beverages may have up to ten-year life cycles.
Private equity funds typically go through the following stages in their lifecycle:
- Capital Raise
It can take two years or more to raise the capital needed. The success of raising capital is dependent on having a strong pitch, a capable team and meeting the minimum threshold.
The fund can be liquidated via a trade sale or an initial public offering. The terms of the liquidation are usually defined in advance and depend on certain criteria such as income or revenue growth. The goal is to get a multiple of your initial purchase value.
- Deal Sourcing
Before the official launch of the fund, the general partners will identify companies or assets they would like to acquire. It is important to demonstrate that these acquisitions are feasible at fair valuations. The fund usually includes a time limit for purchasing or returning investor funds.
- After-Acquisition Improvements
General partners are responsible for the growth of a newly acquired company. It involves increasing revenue, decreasing operating expenses and implementing changes to the business. To achieve these goals, external leverage is often used.
Private equity funds are not only successful in their structuring but also in the ongoing operation, in investment decisions and in their ability to provide returns to investors. This process requires constant adaptation to changing market conditions, regulatory updates, and investment landscapes. For a successful and robust private equity fund, it is important to collaborate with legal, compliance, and financial experts.