Private equity firms have been a historically successful asset class, and the field continues to grow as more would-be portfolio managers join the industry. Many investment bankers have made the switch from public to private equity because the latter has significantly outperformed the Standard & Poor's 500 over the last few decades, fueling greater demand for private equity funds from institutional and individual accredited investors. As demand continues to swell for alternative investments in the private equity space, new managers will need to emerge and provide investors with new opportunities to generate alpha.

Today's many successful private equity firms include Blackstone Group, Apollo Management, TPG Capital, Goldman Sachs Capital Partners and Carlyle Group. However, most firms are small to mid-size shops and can range from just two employees to several hundred workers. Here are several steps managers should follow to launch a private equity fund.

Define the Business Strategy

First, outline your business strategy and differentiate your financial plan from those of competitors and benchmarks. Establishing the business strategy requires significant research into a defined market or individual sector. Some funds focus on energy development, while others may focus on early-stage biotech companies. Ultimately, investors want to know more about your fund's goals.

As you articulate your investment strategy, consider whether you will have a geographic focus. Will the fund focus on one region of the United States? Will it focus on an industry in a certain country? Or will it emphasize a specific strategy in similar emerging markets? Meanwhile, there are several business focuses you could adopt. Will your fund aim to improve your portfolio companies' operational or strategic focus, or will this center entirely on cleaning up their balance sheets?

Remember, private equity typically hinges on investment in companies that are not traded on the public market. It's critical that you to determine the purpose of each investment. For example, is the aim of the investment to grow capital for mergers and acquisitions activity? Or is the goal to raise capital that will allow existing owners to sell their positions in the firm?

Set Up the Business Plan and the Operations

The second step is to write a business plan, which calculates cash flow expectations, establishes your private equity fund's timeline, including the period to raise capital and exit from portfolio investments. Each fund typically has a life of 10 years, although ultimately timelines are up to the manager's discretion. A sound business plan contains a strategy on how the fund will grow over time, a marketing plan to target future investors, and an executive summary, which ties all of these sections and goals together.

Following the establishment of the business plan, set up an external team of consultants that includes independent accountants, attorneys and industry consultants who can provide insight into the industries of the companies in your portfolio. It's also wise to establish an advisory board and explore disaster recovery strategies in case of cyber attacks, steep market downturns, or other portfolio-related threats to the individual fund.

Another important step is to establish the firm and fund name. Additionally, the manager must decide on the roles and titles of the firm's leaders, such as the role of partner or portfolio manager. From there, establish the management team, including the CEO, CFO, chief information security officer and chief compliance officer. First-time managers are more likely to raise more money if they are part of a team that spins out of a previously successful firm.

On the back end, it's essential to establish in-house operations. These tasks include the rent or purchase office space, furniture, technology requirements, and hiring staff. There are several things to consider when hiring staff, such as profit-sharing programs, bonus structures, compensation protocols, health insurance plans and retirement plans.

Establish the Investment Vehicle

After early operations are in order, establish the fund’s legal structure. In the United States, a fund typically assumes the structure of a limited partnership or a limited liability firm. As a founder of the fund, you will be a general partner, meaning that you will have the right to decide the investments that compose the fund.

Your investors will be limited partners who don't have the right to decide which companies are part of your fund. Limited partners are only accountable for losses tied to their individual investment, while general partners handle any additional losses within the fund and liabilities to the broader market.

Ultimately, your lawyer will draft a private placement memorandum and any other operating agreements such as a Limited Partnership Agreement or Articles of Association.

Determine a Fee Structure

The fund manager should determine provisions related to management fees, carried interest and any hurdle rate for performance. Typically, private equity managers receive an annual management fee of 2% of committed capital from investors. So, for every $10 million the fund raises from investors, the manager will collect $200,000 in management fees annually. However, fund managers with less experience may receive a smaller management fee to attract new capital.

Carried interest is commonly set at 20% above an expected return level. Should the hurdle rate be 5% for the fund, you and your investors would split returns at a rate of 20 to 80. During this period, it is also important to establish compliance, risk and valuation guidelines for the fund.

Raise Capital

Next, you will want to have your offering memorandum, subscription agreement, partnership terms, custodial agreement and due diligence questionnaires prepared. Also, marketing material will be needed prior to the process of raising capital. New managers will also want to ensure that they have obtained a proper severance letter from previous employers. A severance letter important because employees require permission to boast about their previous experience and track record.

All of this leads ultimately leads you to the biggest challenge of starting a private equity fund, which is convincing others to invest in your fund. Firstly, prepare to invest your own fund. Fund managers who had had success during their careers will likely be expected to provide at least 2% to 3% of their money to the fund's total capital commitments. New managers with less capital can likely succeed with a commitment of 1% to 2% for their first fund.

In addition to your investment track record and investment strategy, your marketing strategy will be central to raising capital. Due to regulations on who can invest and the unregistered nature of private equity investments, the government says that only institutional investors and accredited investors can provide capital to these funds.

Institutional investors include insurance firms, sovereign wealth funds, financial institutions, pension programs and university endowments. Accredited investors are limited to individuals who meet a specified annual income threshold for two years or maintain a net worth (less the value of their primary residence) of $1 million or more. Additional criteria for other groups that represent accredited investors are discussed in the Securities Act of 1933.

Once a private equity fund has been established, portfolio managers have the capacity to begin building their portfolio. At this point, managers will start to select the companies and assets that fit their investment strategy.

The Bottom Line 

Private equity investments have outperformed the broader U.S. markets over the last few decades. That has generated increased demand from investors seeking new ways to generate superior returns. The above steps can be used as a roadmap for establishing a successful fund.

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