There are many ways to configure private equity (PE) deals: venture capital, real estate, angel investments, and distressed buys, sometimes called vulture funding, to name a few. Some of the most recognizable companies have received some type of PE funding at some point. As the name implies, the invested capital comes from private sources and goes to either private companies not listed on the public stock exchanges, or alternatively, to a public company that is then delisted from a financial exchange.
For instance, the free communication encryption app, WhatsApp, received a $60 million investment from venture capital firm Sequoia Capital (the only VC firm to invest), a deal that translated into $2 billion for the VC firm when Facebook later bought the app for $19 billion. And private equity firm Blackstone Group’s 2007 leveraged buyout of Hilton Hotels made headlines at the time for its $26 billion takeover. Blackstone would later take Hilton public again in 2013 and completely divest its shares in 2018 for more than $14 billion in profit.
Although very different, these deals had important features in common: A private equity fund invested in or bought a company, improved or expanded its operations, and then exited for a profit.
How is a private equity fund structured?
PE firms are created when investment partners join to form a fund. Typically, general partners (GPs) and a management company—together considered the financial sponsor—raise capital from limited partners, or outside investors, who are usually high-net-worth individuals, public or corporate pension funds, endowments, or foundations. These limited partners own the most shares, have limited liability, and pay a management fee to the GPs. The general partner, on the other hand, owns minority shares with full liability, and manages the fund. This arrangement is known as a limited partnership, or LP, and is the most common structure for a private equity fund.
Once reaching their fundraising goal, the partners close the fund and invest the capital into their portfolio of companies. Private equity funds are known as closed-end investments because there is a limited period to raise funds, and once that time has expired, investors may not make any more contributions or withdrawals. Investors will only be able to withdraw their capital and any earned profits when the fund divests from its portfolio company through a sale or initial public offering (IPO).
A PE fund may also be structured as a limited liability company (LLC), which can have many active members managing the business while still retaining limited personal liability.
What groups are needed to fund private equity?
In a private equity fund, it’s the limited partnership agreement that lays out investment and management terms. The limited partners have limited liability, which is capped at the amount they invest. In this structure, the key players are:
- Financial sponsor. This team is composed of a general partner and a management company, which find the investors and raise the capital to invest in companies. The general partner is the active manager who makes the decisions for the fund like managing it, making day-to-day administrative and operating decisions, and identifying new investment opportunities.
- Investors. The limited partners, or investors, are high-net-worth individuals and institutional investors who commit capital to the fund in a partnership agreement that lasts for a certain period of time. They pay a management fee (typically 2%) and possibly a performance fee (20% of the profits above a certain threshold) to GPs, with the expectation to recoup their invested capital and gain profits within that time, usually 10 years.
What is the lifecycle of a private equity fund?
To accomplish their investment goals, private equity firms usually complete a set of core operations throughout the life cycle of a fund, which typically lasts around a decade. The phases and approximate duration of a fund’s life are:
- Raising capital (one to two years). Private equity firms join with limited partners or outside financial institutions, including high-net-worth individuals, endowments, insurance companies, or other investors, and raise a substantial amount of capital to create a fund. They form a limited partner agreement and once the capital has been raised, contributions are closed.
- Sourcing and origination (two to five years). When PE firms are considering companies to add to their portfolio, they thoroughly vet the company’s management, the company’s financial performance, and the industry in which it operates—as well as the services it provides. After sourcing a deal, the investment team analyzes the company’s strategy, risk, business model, and management team, among other factors.
- Implementing strategy and strengthening management (three to seven years). The general partners actively work with their portfolio companies to help set them up for improved profitability. This might include providing financial resources and management expertise. A private equity firm’s level of contribution to the strategy, financial management, or operations may depend on its stake in the portfolio company.
- Exiting (time varies). Private equity firms typically intend to hold their assets for a certain period before exiting and distributing profits to their shareholders. Holding periods vary, and until this time, the firm typically pays down the debt leveraged in funding the transaction, increases working capital and revenue, and supports or hires new management. The goal of an exit is generally to divest by selling the portfolio company or by taking it public through an IPO.
Potential benefits and drawbacks of a private equity fund structure
For investors in private equity, there are both potential rewards and drawbacks of this structure. Investors are taxed at their own income rates and have limited liability, but they give up some flexibility, since they are locked into their investment for a certain period of time.
Potential benefits of a private equity fund structure
- Limited liability. The major advantage to investors entering a limited partner private equity structure is that they limit their exposure to financial liability. Limited partners don’t risk more than their committed capital. The general partner, however, assumes full liability.
- Taxed as regular income. To avoid double taxation, both LPs and LLCs are pass-through entities, meaning that income passes through the business and goes straight to investors. The business pays no corporate tax, and the income is taxed at the shareholders’ individual tax rates for income.
Potential drawbacks of a private equity fund structure
- Loss of some control over investment. Limited partners don’t control or manage the investment. Rather, they pay the general partner to make decisions regarding the investment and actively manage it.
- Typically for wealthy investors. Investors must be accredited to invest in private equity. The current threshold for an individual accredited investor is a net worth of more than $1 million, special employee certification, or for a business, a value of at least $5 million.
- Investors must wait for the exit. Investors typically commit substantial capital to the investment and must wait until the fund exits, up to a decade or more, to recoup the investment and make a profit.
The bottom line
Private equity investments take many forms, but the basic PE structure is the same: A partnership group raises capital, forms a fund, invests in or buys companies, expands or improves them, and finally, exits for a profit—distributing the original investment and profits to its shareholders.
There are pros and cons to the PE structure for investors, who must be accredited and pay management and performance fees to a general partner who controls the investment. Still, they have limited liability for losses and have the opportunity to make large profits when the fund exits its investment.