There are a number of avenues businesses pursue to increase the profitability of their investments, one of which is through private equity funds. While private equity is only available to select investors, information on private equity fund structure, fees, and partnership agreements is readily available. As a private equity deal sourcing platform, an M&A platform, and a portfolio tracking platform, Sourcescrub knows the ins and outs of private equity. Continue reading to get a better understanding of private equity fund structure.
Private Equity Fund Basics
What is private equity?
Private equity, or PE, is composed of funds and investors that directly invest in private companies. Private equity funds are what is known as “closed-end investment vehicles,” meaning that they have a limited window for fundraising. Once that window closes, no more capital can be raised. Private equity funds can engage in leveraged buyouts (LBOs), mezzanine debt, private placement loans, distressed debt, or serve in the portfolio of a fund of funds.
What is the goal of PE?
Private equity’s primary goal is to manage pools of capital that will be invested in companies that represent an opportunity for a high rate of return. Most firms offer the ability and expertise to take underperforming businesses and turn them into stronger ones by increasing operational efficiencies, and with those, earnings. They also increase its profitability. Private equity capital can increase a firm’s working capital, which is an important measure of both a firm’s efficiency and its short-term financial health.
Why do companies want PE?
Private equity is an alternate form of capital that is easy for entrepreneurs and company founders to access with less stress of quarterly performance. These investments come with a fixed time horizon, typically ranging from four to seven years, at which point PE firms hope to profitably exit the investment and move on to the next one.
Why is PE so popular?
There’s a number of reasons why PE is appealing to businesses:
- Private equity is less regulated than other sectors of the financial markets
- Tax consideration provides more flexibility in the structuring of deals
- Strong growth rationale given the rapidly changing global capital markets and the pace of innovation
- Less connectivity-gap constraints in the reach, scope and remit of foreign markets
- The high potential for the capture of niche market segments otherwise not readily accessible to other sectors
- Private equity can take on various forms, from complex leveraged buyouts to venture capitals
- Private equity can be used to fund new technology, make acquisitions, expand working capital, and bolster and solidify a balance sheet.
How PE Funds Are Structured
Usually, a PE fund is built around a LLC or a Limited Partnership. This method exposes investors to less liability while also giving them the opportunity to benefit from a company’s growth and success. A private equity fund has Limited Partners (LP), who typically own 99 percent of shares in a fund and have limited liability, and General Partners (GP), who are responsible for executing and operating the investment, own one percent of shares, and have full liability.
Private equity can be further subdivided into four components: shareholder loans, preferred shares, CCPPO shares, and ordinary shares.
- Shareholder loans: A form of financing that is provided by shareholders. Usually, this is junior debt that is part of the company’s debt portfolio, and can be traded as equity.
- Preferred shares: A share whose payment takes priority over that of other common stock.
- CCPPO shares: Cumulative, Convertible, Participating, Preferred-dividend Ordinary shares. These are a rarity, but they are shares that have many features, including cumulative dividends.
- Ordinary shares: Exactly what it sounds like, shares in a given venture.
The Role of the PE Firm
A private equity firm is an investment management company that provides financial backing and makes investments in the private equity of startup or operating companies through a variety of loosely affiliated investment strategies. These strategies include leveraged buyout, venture capital, and growth capital. Often described as a financial sponsor, each firm will raise funds that will be invested in accordance with one or more specific investment strategies.
The equity proportion typically accounts for 30 percent to 40 percent of funding in a buyout. Private equity firms tend to invest in the equity stake with an exit plan of four to seven years. Sources of equity funding include management, private equity funds, subordinated debt holders, and investment banks. In most cases, the equity fraction consists of a combination of all these sources. Each fund generally makes 10 to 12 investments and the life of a fund is usually five to seven years.
Most venture and private equity funds use a limited partnership as their legal structure, which involves two main types of actors: (1) a general partner (GP) and (2) limited partners (LPs).
The general partner oversees and runs the business while limited partners do not partake in managing the business. However, the general partner has unlimited liability for the debt, and any limited partners have limited liability up to the amount of their investment.
Also known as the management firm, GPs have unlimited liability and the LPs, or investors, have limited liability as they are not involved with day-to-day fund operations. GPs receive a management fee and a percentage of the profits. They are also responsible for attaining capital commitments from investors known as limited partners (LPs). 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.
LPs usually operate under a fixed-life investment vehicle. They receive a portion of the income and capital gains, but they have no influence over investment decisions. Because of this, their liability only extends up to the full amount of money they invest in the fund.
Management companies are companies that are setup to manage a group of properties, mutual funds, and investment funds.
The Importance of Partnership Agreements
A Partnership Agreement is a document that the two owners of a company work on together. If the company is an LLC, the agreement is instead called an Operating Agreement. If the company is a corporation, it’s called a Shareholder Agreement. If both form a partnership, then you have the Partnership Agreement. The agreement defines the expectations of each company in the context of the other, and breaks down how the company will be run and who will become responsible for what. Getting a partnership agreement helps reduce the friction down the road should there be any obstacles.
What separates each classification of partners in this agreement is the risk to each. When an agreement is made, the liability has to be defined out of the gate, otherwise you’re in legal hot water. 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).
PE vs VC Considerations
Venture capital is a form of private equity, but there are some important differences between the two.
Private Equity vs VC Funding
The difference boils down to scale and aims, though both are investors. Private equity, is, at its most basic, equity—shares representing ownership. Private equity is the source of investment capital from high net worth individuals and/or firms. These investors buy shares of private companies, or gain control of public ones (with the goal of taking them private).
Venture capital, on the other hand, is financing that is given to startups and small businesses, with the goal of having these companies break out. Usually funding comes from investors, investment banks, and other financial institutions. There are also other perks from getting VC beyond capital, including managerial and administrative expertise.
Focus of VC Firms
Venture capital firms generally utilize pooled investment funds that manage the money of investors who seek private equity stakes in startups and small to medium-sized enterprises with strong growth potential. These investments are generally characterized as very high-risk/high-return opportunities.
Focus of PE Firms
Private equity firms are a collective investment scheme used for making investments in various equity (and to a lesser extent, debt) securities according to one of the investment strategies associated with private equity. They are typically open only to accredited investors and qualified clients.
An accredited investor is a special status under financial regulation laws. In the U.S. this status is regulated under Regulation D, by the Securities and Exchange Commission (SEC). Accredited investors are granted additional privileges and usually must satisfy requirements to qualify, regarding:
- Net worth
- Asset size
- Governance status
- Professional experience
In the United States, a net worth of at least $1,000,000 (excluding the value of one's primary residence), or have income at least $200,000 each year for the last two years (or $300,000 combined income if married).
Only accredited investors are allowed to buy, sell, trade, or invest in securities that may not be registered with financial authorities, because they are considered inherently more risky because they lack the normal disclosures that come with SEC registration.
Accredited investors may include:
- Natural high net worth individuals (HNWI)
- Insurance companies
Fees & How PE Firms Make Money
PE funds make money primarily through carried interest, and charging fees based on the assets under managements, or AUM.
Carried interest is the primary moneymaker for PE funds. This is the firm’s share of capital gains generated by a given fund, which come from profits on portfolio investment. Usually, these returns are realized through selling the company or taking it public. Most firms can receive 20 percent of the carried interest according to their partnership, however, there are requirements for rate of return that are predetermined, so investors also get adequate returns.
Generally speaking, the management fee is about 2 percent of the capital committed to invest in the fund. 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 or deal fees. As with any fund, the management fee is charged even if it doesn't generate a positive return.
This fee 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 percent, are normally contingent on the fund providing a positive return. They help bring the interests of both investors and the fund manager in line.
Importance of Return & Reputation
Better returns mean better reputation, better reputation means more and better deals for more returns. Investment banks compete in the same way many service industries do, by filling their ranks with the best talent, attempting to entice and attract new clients, and incentivizing clients to choose their services over the services of other firms.
Factors that affect PE firms reputation include:
- Performance of analyst recommendations
- Debt offering capabilities
- Distributional abilities
- Market making prowess
- Pricing accuracy
- Past deal success
Post-deal marketing is an important part of both leveraging and boosting both reputation and return.
PE Fund Lifecycle
There are several different stages of a private equity fund that take place over the course of the four to seven year span that they have to raise capital.
The Marketing Period
The first task for a manager of a new fund is to raise the capital for it. This process begins before the formation of the fund. The manager will determine the terms of the fund and draft the offering documents, which include the limited partnership agreement, private placement memorandum, and subscription agreements. Investors will negotiate the fund documents or seek to modify the terms of the partnership agreement.
The manager will approach potential investors and once they have obtained sufficient investor interest, they will hold an initial closing for the fund. The fund will commence its operations and the initial investors will be admitted as partners. Often, the marketing period can continue past the initial closing, usually anywhere from six to 18 months, so the fund can amass additional capital in subsequent closings. The marketing period can end earlier if the fund reaches its predetermined fundraising cap.
The Commitment Period
Also called the investment period, this marks the official start of the fund’s operations, and typically lasts four to six years after the initial closing is completed. There is often some overlap between the marketing period and the commitment period because marketing typically continues past the first closing,
This is also when the fund manager begins deploying the fund’s capital into investments. Throughout this period, the manager sources new investments and liquidates capital from investors as needed on a deal-by-deal basis to fund each new investment. This is the only period, with few exceptions during the post-commitment period, the fund manager can freely enter into new investments on behalf of the fund.
The Post-Commitment Period
Also commonly referred to as the divestment period, this is when the fund’s investments are liquidated over the course of four to seven years. Unlike the commitment period, new investments are generally prohibited during the post-commitment period. Certain circumstances are the exception, such as follow-on investments in the already existing investments, or investments that were committed prior to the end of the investment period.
Many limited partnership agreements include the ability to extend the term of the fund for certain limited periods. The terms of these extensions can vary significantly, and include:
- The number of times the fund manager may extend the term (often 1-3 times)
- The length of the extension (often 1-2 years)
- Whether the fund manager must obtain the investors’ consent to the extension
Extensions are often used to achieve the best return on the fund’s investments, since the process of divesting interests in private companies can take a significant amount of time.
Dissolution & Liquidation
At the end of the post-commitment period the fund will be dissolved, unless the fund’s term is extended. All remaining investments must be liquidated by the fund manager, and the proceeds distributed to investors and the fund manager according to the terms of a pre-arranged distribution waterfall.
Choosing an Appropriate Term for a Fund
A fund’s individual investment program will determine the appropriate length for the commitment and post-commitment periods. A shorter investment period is preferable for funds with quickly maturing or relatively liquid investments. A longer investment period is common for funds that make investments with a longer time horizon, like emerging growth companies or real estate.
Types of Exits
Exit strategies include IPOs and sale of the business to another private equity firm or strategic buyer. There are different types of exits: total exits or partial exits.
A full exit results in the sale of all VC holdings within one year of the exit, while a partial exit involves sale of only part of the holdings within that period.
There could be a private placement, where another investor purchases a piece of the business. There is also corporate restructuring, where external investors get involved and increase their position in the business by partially acquiring the private equity firm’s stake. Corporate venturing could happen, in which the management increases its ownership in the business.
A flotation or an IPO is a hybrid strategy of both total and partial exit, which involves the company being listed on a public stock exchange.
Typically, only a fraction of a company is sold in an IPO, ranging from 25 percent to 50 percent of the business. When the company is listed and traded publicly, private equity firms exit the company by slowly unwinding their remaining ownership stake in the business.
- When does the exit need to take place? What is the investment horizon?
- Is the management team amenable and ready for an exit?
- What exit routes are available?
- Is the existing capital structure of the business appropriate?
- Is the business strategy appropriate?
- Who are the potential acquirers and buyers? Is it another private equity firm or a strategic buyer?
- What Internal Rate of Return (IRR) will be achieved?
Limited Partnership Agreements & Roles Within the Organization
Private equity firms are 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. The general partner invests the fund’s committed capital in private companies and manages the portfolio of investments, with the goal to exit the investments for sizable returns in the future. A general partner may manage one or a few funds that may have different investment restrictions such as geography, industry or typical size of each investment.
Similarly to the funds they manage and the limited partnership agreements they enter, private equity firms are composed of a number of roles and responsibilities. Equity firms are usually managed by a hierarchy that starts at the bottom with analysts or interns and rises to the top with partners. Check out our blog to learn more about private equity and how Sourcescrub can enhance your investment and fundraising efforts.