What Is the Structure of a Private Equity Fund?

In the 1980s, technology in the United States got a much-needed boost from venture capital. Many fledgling companies and start-ups like Apple raised funds from private equity sources rather than going to the public market.

These funds are not readily available for the average investor and typically require a minimum investment. Private equity funds are commonly geared toward institutional investors, such as mutual fund companies, pension holders, and insurance companies.

What Is a Private Equity Fund?

Private equity funds are closed-end funds and an alternative investment class. Their capital is not 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).

Private Equity Fund Structure

Private equity funds can engage in leveraged buyouts (LBOs), mezzanine debt, private placement loans, distressed debt, or 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. Under the structure of each fund, GPs are given the right to manage the private equity fund and pick which investments they will include in their portfolios. GPs are also responsible for attaining capital commitments from investors known as limited partners (LPs), which include institutions—pension funds, university endowments, insurance companies—and high-net-worth individuals.

Limited Partnership Agreement

Institutional and individual investors agree to specific investment terms presented in a limited partnership agreement. 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. However, GPs are fully liable to the market, meaning if the fund loses everything and its account turns negative, GPs are responsible for any debts or obligations the fund owes.

The LPA outlines an important life cycle metric called 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. This period typically lasts about 12 months
• The period of deal-sourcing and investing.
• The period of portfolio management 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. In addition to the decision rights, the GPs receive a management fee and a “carry.”

The management fee is typically 2% of the capital in the fund. 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 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 passed on to the general partner (GP). This "carry" can be as high as 20% of excess gross profits for the fund and contingent on the fund providing a positive return.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 may include industry type, company size, diversification requirements, and the location of potential acquisition targets. LPs do not have veto rights over individual investments.

GPs can only allocate a specific amount of money from the fund to each deal they finance. Under these terms, the fund must borrow the rest of its capital from banks that may lend at different multiples of a cash flow, which 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.

The Bottom Line

Private equity funds offer unique investment opportunities to high-net-worth and institutional investors. Typically, PE funds have a limited duration, require 2% annual management fees and 20% performance fees, and require LPs to assume liability for their investment, while GPs maintain complete liability.