Although the history of modern private equity investments dates back to the beginning of the last century, they didn’t really gain prominence until the 1980s. That’s the time when technology in the United States received a much-needed boost from venture capital. .
Many struggling start-ups were able to raise funds from private sources rather than go to the public market. Some of the big names we know today – Apple, for example – were able to put their names on the map thanks to funding they received from private equity.
Although these funds promise investors great returns, they may not be available to the average investor. Businesses generally require a minimum investment of $ 200,000 or more, which means that private equity is aimed at institutional investors or those who have a lot of money at their disposal.
If that’s you and you can meet that initial minimum requirement, you’ve cleared the first hurdle. But before making that investment in a private equity fund, you should have a good understanding of the typical structures of these funds.
- Private equity funds are closed 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 describes the amount of risk each party assumes 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.
Basics of private equity funds
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 and acquire shares in companies.
Funds may consider buying shares in private companies or public companies with the intention of excluding the latter from public stock exchanges to convert them into private companies. After a certain period of time, the private equity fund generally disposes of 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 the 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 established in a limited partnership agreement (LPA). ).
For the most part, private equity funds have been regulated much less than other assets on the market. This is because high net worth investors are considered to be better equipped to bear losses than average investors. But in the aftermath of the financial crisis, the government has scrutinized private equity with far more scrutiny than ever.
If you are familiar with the fee structure of a hedge fund, you will notice that it is very similar to that of a private equity fund. It charges both a management fee and a performance fee.
The management fee is approximately 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, trading fees, basically everything needed to manage the fund. As with any fund, the management fee is charged even if it does not generate a positive return.
The performance fee, on the other hand, is a percentage of the profits generated by the fund that are transferred to the general partner (GP). These fees, which can be as high as 20%, are typically dependent on the fund delivering a positive return. The rationale for performance fees is that they help align the interests of both investors and the fund manager. If the fund manager can do this successfully, he will be able to justify his performance fee.
Partners and responsibilities
Private equity funds can participate in leveraged buyouts (LBOs), mezzanine debt, private placement loans, distressed debt, or serve in a fund of funds portfolio. While there are many different opportunities for investors, these funds are more 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 partners of the private equity fund are known as general partners. Under the structure of each fund, GPs have the right to manage the private equity fund and choose which investments to include in their portfolios. GPs are also responsible for obtaining capital commitments from investors known as limited partners (LPs). This class of investors generally includes institutions (pension funds, college grants, insurance companies) and high-net-worth individuals.
Limited partners have no influence over investment decisions. At the time the capital is raised, the exact investments included in the fund are unknown. However, LPs may decide not to provide any additional investment to the fund if they are dissatisfied with the fund or with 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 partner classification in this arrangement is the risk to each. LPs are liable up to the full amount of money they invest in the fund. However, GPs are fully accountable to the market, which means that if the fund loses everything and your account turns negative, GPs are liable for any debts or obligations that the fund owes.
The LPA also describes an important life cycle metric known as “Fund Duration.” PE funds traditionally have a finite duration of 10 years, consisting of five different stages:
- The organization and training.
- The fundraising period. This period usually lasts two years.
- The three-year period of contracting and investment.
- The portfolio management period.
- Up to seven years of exiting existing investments through IPOs, secondary markets, or commercial sales.
Private equity funds typically exit each operation within a finite period of time due to the incentive structure and the possible desire of a GP 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 business.
Notable private equity outflows include the Blackstone Group (BX) 2013 initial public offering of Hilton Worldwide Holdings (HLT) which provided the deal’s architects with a paper profit of $ 8.5 billion.
Investment structure and payments
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 decision rights, GPs receive a management fee and a “carry”.
The LPA traditionally describes the management fees for the fund’s general partners. It is common for private equity funds to require an annual fee of 2% of invested capital to pay company salaries, contract contracting and legal services, data and research costs, marketing, and fixed and variable costs. additional. For example, if a private equity firm raised a fund of $ 500 million, it would raise $ 10 million each year to pay for expenses. Over the duration of the 10-year fund cycle, the private equity firm raises $ 100 million in fees, which means that $ 400 million is actually invested during that decade.
Private equity firms also receive a carry, which is a performance fee that is traditionally 20% of the fund’s excess gross earnings. Investors are often willing to pay these fees because of the fund’s ability to help manage and mitigate management and corporate governance issues that could adversely affect a publicly traded company.
The LPA also includes restrictions placed on GPs regarding the types of investment they may consider. These restrictions may include the type of industry, the size of the company, diversification requirements, and the location of potential acquisition targets. In addition, GPs can only allocate a specific amount of money from the fund to each operation they finance. Under these terms, the fund must borrow the remainder of its capital from banks that can 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 arrangement is important for limited partners because multiple investments combined improve the incentive structure for GPs. Investing in multiple companies poses a risk to GPs and could reduce the potential for carry-overs, should a past or future deal underperform or turn negative.
Meanwhile, LPs do not have veto rights over individual investments. This is important because LPs, which outnumber GPs in the fund, would commonly oppose certain investments due to governance issues, particularly in the early stages of company identification and financing. Multiple vetoes of companies can reduce the positive incentives created by combining fund investments.
The bottom line
Private equity firms offer unique investment opportunities to institutional and high net worth investors. But anyone who wants to invest in a private investment fund must first understand its structure to know the amount of time that will be required to invest, all associated management and performance fees and associated liabilities.
PE funds typically have a duration of 10 years, require annual management fees of 2% and performance fees of 20%, and require LPs to take responsibility for their individual investment, while GPs maintain the full responsibility.