Private equity 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 and taking them private. After a finite period, the private equity fund will divest its holdings through a number of options, including initial public offerings (IPOs) or sales to another private equity firm.

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).

Before investing in a private equity fund, investors need to have a good grasp of these funds' typical structures. (For an overview, read "What Is Private Equity?")

Partners and Key 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. (For more, see "Can Mutual Funds Invest in Private Equity?")

Those seeking 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 (GPs). 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, etc.) and high-net-worth individuals.

Limited partners have no influence over investment decisions. At the time that capital is raised, the exact investments that will be 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.

The Limited Partnership Agreement (LPA)

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 that they invest in the fund. However, GPs are fully liable to the market, meaning that if the fund loses everything and its account turns negative, GPs are responsible for any debts or obligations.

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. These are the organization and formation; the fund-raising period (typically two years); the period of deal-sourcing and investing (three years); the period of portfolio management; and 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, might not attract the desired capital to sell a company.

Notable private equity exits include Blackstone Group's (NYSE: BX) 2013 IPO of Hilton Worldwide Holdings, Inc. (NYSE: HLT) that provided the deal's architects a paper profit of $12 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.”

Traditionally, the LPA will outline management fees for general partners of the fund. It's common that private equity funds will 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 would collect $50 million in fees, meaning that $450 million would actually be 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.

Additional Restrictions and Structural Components

The LPA also includes restrictions imposed on GPs regarding the types of investment they might 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 might be lending 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 might reduce 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 seeking to invest in a PE fund must first understand their structure so that 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.