We previously discussed financial buyers in the article 5 Major Differences Between Strategic and Financial Buyers. There are various types of financial buyers, some more active than others. Private equity groups are the most active financial acquirers, so understanding their structure can help in knowing if they would be a good fit for your needs when raising capital or selling your business.
“Private equity” refers to direct investments in private companies or public companies which are then de-listed from public exchanges (known as “going-private” or a “take private”). By definition, these private equity acquisitions and investments are illiquid and are longer term in nature. Consequently, the capital is raised through private partnerships which are managed by entities known as private equity firms.
The private equity firm is typically made up of limited partners (“LPs”) and general partners (“GPs”). The LPs are the outside investors. They provide the capital and typically consist of institutional investors such as insurance companies, endowment funds (Harvard, Stanford, Princeton and Yale all aggressively invest their endowment in private equity), foundations, banks, retirement / pension funds, family investment offices as well as high net worth individuals. They are called limited partners in the sense that their liability extends only to the capital they contribute. Generally, the minimum commitment for an LP is $1 million.
GPs are the professional investors who manage the private equity firm and deploy the pool of capital. They are responsible for all parts of the investment cycle including deal sourcing and origination, investment decision-making and transaction structuring, portfolio management (the act of overseeing the investments that they have made) and exit strategies.
Most private equity funds are organized as limited partnerships or limited liability companies and have a finite life (usually 10 years). A fund goes through a number of overlapping stages:
- Organization/Formation (Year 0)
- Fund Raising (Years 0 to 2)
- Deal Sourcing and Investing (Years 1 to 4)
- Portfolio Management (Years 2 to 7)
- Exiting Investments (Years 3 to 10)
Note that successful private equity firms typically look to raise multiple, successive funds. For example, ABC Private Equity firm will raise the fund ABC Capital Partners Fund I and begin deal sourcing and making investments / acquisitions. After a few years and usually after they have invested 70% of the capital from Fund I, they will start the process over and begin fund raising ABC Capital Partners Fund II.
The GPs charge a management fee from the LPs’ capital contribution to cover the operating expenses of the firm, including salaries, data and research services, deal sourcing services, office leases, marketing, travel and administration costs. Historically, annual management fees have been approximately 2% of the fund size. Back to our example, suppose ABC Capital Partners raised a $100 million fund with a 2% management fee. Each year, the GPs would draw $2 million of the LP’s capital to pay expenses. So over the 10 year life of the fund, the firm would collect $20 million from the LPs for expenses. Only $80 million of the $100 million fund would be actually invested.
In addition to the management fee, the GPs also receive a portion of the proceeds from the fund. Proceeds can be in the form of dividends or the proceeds from the sale of portfolio companies. The split of the proceeds is governed by an agreement between the LPs and GPs. Generally, after the LPs have recovered 100% of their invested capital, the remaining proceeds are split between the LPs and GPs with 80% going to LPs and 20% to GPs. The portion of the proceeds that go to GPs is known as “carried interest” or “carry”. In the last few years, Congress has threatened some parts of the industry by considering changing the way ‘carry’ is taxed (paywall).
Finally, the agreement between LPs and GPs will typically include contractual provisions which specify what the private equity firm can and cannot do. Broadly speaking, provisions will be placed around the management of the fund, the activities of the GPs and the types of investments the GPs can make. In many cases, the private equity fund will have a limited partner advisory committee to oversee investment decisions, ensure there are no related party issues and to deal with questions of fund extensions or other problems that may arise.