PE Basics Every Selling CEO Should Know

Thinking of selling your business?

If you’re considering financial buyers — firms and executives who make investments on companies in order to realize a return — you’ll certainly run into private equity firms throughout the process.

Before you talk to PE firms about their interest in your company, it’s helpful to know the basics of how firms are structured.

Private equity refers to capital raised through private partnerships and not listed on a public exchange. A private equity investment is a direct investment in a private company; these investments are managed by private equity firms.

The number of private equity firms has grown rapidly in recent years. According to Pitchbook, there were 3,530 private equity firms globally in 2014 — a 143% increase from the number in 2000.

Limited Partners: The Capital Providers

Limited partners, or LPs, are outside investors who provide capital for the firm. Typical LPs include foundations, banks, pension funds, family offices, high net worth individuals, and endowment funds at universities. These partners have limited liability (hence the name) — they are only on the hook for the amount of capital they invest and are ineligible from any other debt obligations. LPs usually have some control over fund management and the type of investments GPs can make. Minimum contributions vary by fund, but at minimum most LPs commit at least $1 million.

General Partners: The Capital Managers

General Partners, or GPs, manage the firm and decide how to invest its capital. GPs oversee business development, make the final decisions on investments and transaction structures, manage the firm’s current portfolio (companies they’ve invested in), and decide on exit strategies. A GP’s title at a firm is typically “Managing Director.”

GPs at private equity firms typically raise funds from LPs every 3-10 years as capital is invested. Each fund’s lifecycle consists of the following overlapping stages:

• Fundraising
• Deal sourcing and investing
• Portfolio management
• Exiting investments and return on capital

Other Staff

Other members of a firm’s team include:

• Associates: Entry-level employees; typically have not received an MBA and may have 2-4 years of experience in related fields like investment banking.
• Senior Associates: Associates who have been promoted (usually after 2-3 years) or hired after earning an MBA.
• Vice Presidents: More senior employees who lead deals and work closely with portfolio companies.

How GPs and LPs Make Money

PE firms manage millions of dollars, which they invest directly into portfolio companies. In a few years, after adding operational and business value, they turn around and sell those companies for a return (if all goes according to plan).

GPs and LPs both receive a portion of the proceeds from the fund. Agreements vary, but the typical structure entails 80% of proceeds going to LPs and 20% to GPs. This 20% is known as “carried interest” or “carry.” (This topic has been in the news lately as some legislators look to close a loophole that allows GPs to pay a lower tax rate on this type of income).

General partners also charge limited partners a management fee to cover firm expenses (e.g., salaries, marketing, or travel). Management fees are typically around 2% of the fund size.