Looking to get a deeper understanding of private equity fund structure? As a private company intelligence platform that works with many of today's leading firms, Sourcescrub knows the ins and outs of private equity (PE). Continue reading to learn more about PE partners, fund lifecycles, exit strategies, and much more.
Private equity is a type of investment where private funds are provided by institutions and wealthy individuals. These funds are then used to invest directly in private companies or to buy out and delist public companies from public stock exchanges. It's a longer-term, closed-end investment play, which means that there is a finite window of time in which funds can be raised. Private equity funding can take many forms; some of the more popular are venture capital, real estate, funds of funds, and distressed funding.
Fund size refers to the amount of money in a particular fund: the more money in the fund, the larger the size. Fund size is determined by multiple factors including the number of investors, estimated deal size, average number of expected deals, and more. While bigger funds attract more attention and generate higher management fees, there is also greater risk involved. Some research shows that smaller funds actually generate higher IRR.
Private equity's primary goal is to manage pools of capital and invest them in companies that generate a high rate of return. This is often done by injecting capital into growing or underperforming businesses to increase their operational efficiencies and subsequent earnings and profitability. Because the funds in private equity are largely illiquid, investors often only make money during a liquidity event. Two types of these events, also known as exit strategies, include an initial public offering (IPO) when a company goes public and garners an increased value per share or after a merger or acquisition when the company is sold at a profit to another firm or buyer.
There are a number of reasons why PE is appealing to businesses:
PE funds involve 4 key entities, each with their own responsibilities, rewards, and risks.
The management company, or private equity firm, is essentially an operating entity that employs General Partners and their investment teams. Examples of top private equity firms' management companies include the Blackstone Group and Thoma Bravo.
General Partners (GPs), or fund managers, are employed by and represent the private equity firm or management company. They are responsible for defining fund size, securing capital commitments from Limited Partners, and choosing in which portfolio companies to invest. On one hand, they assume all liability for the fund, but on the other hand, they earn hefty performance fees if the fund is successful.
Limited Partners (LPs), or simply Investors, are institutions and wealthy individuals responsible for providing the capital for the private equity fund. LPs have limited liability for the fund, but they also don't have any say in the exact companies the fund invests in. They make money by collecting performance fees for successful funds.
Most private equity funds are established as a Limited Liability Company (LLC) or a Limited Partnership (LP). This has two key benefits for Limited Partners:
The following video provides a comprehensive overview of a private equity fund's structure and roles:
Limited Partnership Agreements (LPAs) are the investment terms that are agreed upon between General Partners or Private Equity Firms and Limited Partners. LPAs cover a number of stipulations, including:
PE funds make money primarily through two types of fees: management and performance.
These are the annual fees collected by the management company or PE firm to cover the expenses associated with managing the fund. These include marketing, technology platforms, firm salaries, etc. Management fees are usually 2% of assets under management (AUM) and are charged regardless of whether the fund generates a positive return.
This fee is collected only when a fund turns a profit. Sometimes referred to as "carried interest," performance fees are paid out to General Partners after Limited Partners have received their cuts. Performance fees are usually 20% of gross profits.
Private equity fund lifecycles are categorized differently across firms, and durations vary. However, many experts agree the typical term can be broken down into 4 phases and lasts between 10 - 15 years.
Average Duration: 1-2 years
During this first phase, the General Partners must find investors to raise capital for the fund. They also assemble the PE firm team that will assist in sourcing and managing portfolio companies, as well as draft the limited partnership agreement. Once sufficient funds have been raised, the fund will hold its initial closing.
Average Duration: 2-5 years
This is the time when the General Partners work with their investment teams to find and close promising investment opportunities. These companies must align with the partners' investment thesis and the portfolio company restrictions set forth in the LPA.
While many of these opportunities arise through partner networking and relationships, more PE firms are investing in direct deal sourcing. However, manually finding and researching promising companies is time-consuming and tedious, so many PE firms are accelerating this process by using deal sourcing platforms.
Average Duration: 3-7+ years
Phase 3 is usually the longest of the 4 lifecycle stages. It represents the time when General Partners and their firms work with each of the companies they chose to invest in to maximize their returns. This is done by providing resources, expertise, and support to help these businesses improve operational efficiencies, hire top talent, enter new markets, sunset or develop products, and achieve other key strategic milestones.
Average Duration: Varies
Once it's possible for a portfolio company to meet the fund's desired rate of return, it's time to exit. While it's important for GPs to wait for the right buyer and/or market conditions prior to exiting, it's also worth noting the longer an investment stays in a portfolio, the harder it is to hit the target internal rate of return (IRR).
Sometimes a portfolio company may require more capital in addition to a fund's initial investment. In these cases, a "follow-on" investment is made, usually during phase 3 of the fund lifecycle.
Once a fund's agreed-upon lifespan has been met, some LPAs allow General Partners to extend the fund's term. This is often allowed twice, for a period of one year each time. During term extensions, General Partners work hard to improve remaining portfolio companies' rates of return and secure successful and lucrative exits.
There are a number of ways for PE firms to successfully exit investments and close their funds, including:
According to Forbes, just 2% of the US population is eligible to personally invest in PE funds. Investing in a PE fund requires a minimum of $1,000,000 in personal assets (minus your primary residence), or $200,000 in annual income. PE funds with more than 100 investors require $5 million in investments. This is why private equity funds are composed largely of institutional investors like family offices and endowments.
"Private equity" and "venture capital" are often used interchangeably. However, venture capital (VC) is a common type of private equity focused specifically on raising funds for newer, smaller companies, or startups, that are usually later acquired by another company or taken public. "Buyouts" are another common type of PE focused on investing in more mature public or private companies and then selling them at a profit. Other forms of PE exist as well.
A "fund of funds" is a specific type of private equity investment. It refers to private equity funds that invest in PE funds, which then invest in portfolio companies. Funds of funds have many benefits, including diversification, but also present their own challenges, risks, and considerations.
Private equity is a complex and ever-evolving space. Many of the traditional tools and tactics are no longer as effective as they used to be. Modern dealmakers who are ready to embrace data and technology as part of their fund structure strategy and lifecycle are rising to the top.
Sourcescrub works with many of these leading new school firms, including Silversmith Capital Partners, TA Associates, and LFM Capital. To learn more about how these modern dealmakers approach PE fund structure, deal sourcing, building teams, and more, download this free 5-step playbook to take control of your deal flow.