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.
- 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 up to the full amount of money they invest, while general partners are fully liable to the market.
Private Equity Fund Basics
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.
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 offerings (IPOs) or sales to other private equity firms.
Unlike public funds, the capital of private equity funds is not available on a public stock exchange.
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 financial crisis, the government has looked at private equity with far more scrutiny than ever before.
If you're familiar with the fee structure of a hedge fund, you'll notice it's very similar to that of the 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, he is able to justify his performance fee.
Partners and Responsibilities
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. While many different opportunities exist for investors, these funds are most commonly designed as limited partnerships.
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 its 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 a limited partnership agreement. What separates each classification of partners in this agreement is the risk to each. LPs are liable 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 two years.
- The three-year period of deal-sourcing and investing.
- The period of portfolio management.
- The up to seven years of 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.
Notable private equity exits include Blackstone Group's (BX) 2013 IPO of Hilton Worldwide Holdings (HLT) that provided the deal's architects a paper profit of $8.5 billion.
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.
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 it finances. 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 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 educe the positive incentives created by the commingling of fund investments.
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 he or she is 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 a 10-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.