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Private equity funds aren’t readily available to the average investor and they typically require a minimum investment. They’re commonly geared toward institutional investors such as mutual fund companies, pension holders, and insurance companies. They’re closed-end funds that aren’t listed on public exchanges.
Technology in the United States got a much-needed boost from venture capital in the 1980s and many fledgling companies and start-ups like Apple raised funds from private equity sources rather than going to the public market.
Key Takeaways
- Private equity funds are closed-end funds that aren’t listed on public exchanges.
- Their fees include management and performance costs.
- Private equity fund partners are referred to as general partners and investors or limited partners.
- Limited partners are liable for an amount up to the money they invest.
- General partners are fully liable to the market.
What Is a Private Equity Fund?
Private equity funds are closed-end funds and an alternative investment class. Their capital isn’t listed on a public exchange. Private equity funds allow high-net-worth individuals and a variety of institutions to invest in and acquire ownership in companies.
The private equity fund generally divests its holdings through several options, including initial public offerings (IPOs) or sales to other private equity firms. Minimum investments vary for each fund. The structure of private equity funds historically follows a framework that includes classes of fund partners, management fees, investment horizons, and other key factors laid out in a limited partnership agreement (LPA).
Important
Private equity funds have historically faced less regulation but the U.S. government has looked at private equity with far more scrutiny following the 2008 financial crisis.
Private Equity Fund Structure
Private equity funds can engage in leveraged buyouts (LBOs), mezzanine debt, private placement loans, and distressed debt, or they can serve in the portfolio of a fund of funds. These funds are most commonly designed as limited partnerships.
The private equity fund’s partners are known as general partners (GPs). GPs are given the right under the structure of each fund to manage the private equity fund and choose which investments they’ll include in their portfolios.
GPs are also responsible for attaining capital commitments from investors known as limited partners (LPs) which include institutions such as pension funds, university endowments, and insurance companies as well as high-net-worth individuals.
Fast Fact
Limited partners don’t influence investment decisions. The exact investments included in the fund are unknown when capital is raised. LPs can withhold additional investment to the fund if they’re dissatisfied with the fund or the portfolio manager, however.
Limited Partnership Agreement
Institutional and individual investors agree to specific investment terms presented in a limited partnership agreement (LPA). What separates each classification of partners in this agreement is the risk to each.
LPs are liable for up to the full amount of money they invest in the fund. GPs are fully liable to the market, however. They’re responsible for any debts or obligations the fund owes if the fund loses everything and its account turns negative.
The LPA 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:
- The organization and formation
- The fund-raising period which typically lasts about 12 months
- The period of deal-sourcing and investing
- The period of portfolio management which is about five years with a possible one-year extension
- The exiting from existing investments through IPOs, secondary markets, or trade sales
Payout and Fees
The most important components of any fund’s LPA are the return on investment and the cost of doing business. The LPA traditionally outlines management fees for general partners. The GPs receive a management fee and a “carry” in addition to the decision rights.
The management fee is typically 1% to 2% of the capital in the fund. A fund with assets under management (AUM) of $1 billion would charge a maximum management fee of $20 million. This fee covers the fund’s operational and administrative costs. The management fee is charged even if the fund doesn’t generate a positive return.
The performance fee is a percentage of the profits generated by the fund and it’s passed on to the general partner (GP). This “carry” can be as high as 15% to 20% of excess gross profits for the fund and is contingent on the fund providing a positive return.
Fast Fact
Investors are usually willing to pay these fees to help manage and mitigate corporate governance and management issues that might negatively affect a public company.
Investment Restrictions
The LPA includes restrictions imposed on GPs regarding the types of investment they consider. These restrictions can include industry type, company size, diversification requirements, and the location of potential acquisition targets. LPs don’t have veto rights over individual investments.
GPs can only allocate a specific amount of money from the fund to each deal they finance. The fund must borrow the rest of its capital from banks that may lend at different multiples of a cash flow under these terms and this can test the profitability of potential deals.
Limiting funding to a specific deal is important to limited partners because holding several investments bundled together improves the incentive structure for the GPs. Investing in multiple companies provides risk to the GPs and may reduce the potential carry should a past or future deal underperform or turn negative.
What Is an Alternative Investment?
Alternative investments don’t fall into one of the traditional categories like stocks, bonds, and cash. They include hedge funds, private equity funds, digital assets, and real assets.
Why Do Private Equity Funds Charge a Performance Fee?
The rationale behind performance fees is that they help align the interests of investors and the fund manager. A fund manager can justify their performance fee if they can do that successfully.
What Affects an Exit Strategy for a Private Equity Fund?
Private equity funds typically exit each deal within a finite period due to the incentive structure and a GP’s possible desire to raise a new fund. The time frame can be affected by negative market conditions or periods when various exit options such as IPOs may not attract the desired capital to sell a company.
The Bottom Line
Private equity funds offer unique investment opportunities to high-net-worth and institutional investors. PE funds typically have a limited duration. They can require 2% annual management fees and 20% performance fees. They can require LPs to assume liability for their investment while GPs maintain complete liability.
Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.
