How to structure a fund?
Private equity funds are considered to be private investment vehicles, meaning they are not available on public exchanges. They allow a limited pool of institutions and individuals to become their investors and receive ownership in fund companies.
Although private equity funds are not accessible to public exchanges, they can purchase public assets and make them private. Then, they can sell acquired holdings through IPO (or Initial Public Offering) or to other private equities.
The structure of these funds always followed a similar pattern, which incorporates different categories of fund partners, fees, investment opportunities, and other crucial variables written in a limited partnership agreement, but the minimum investments differ for each fund.
For most of the time, private equity funds have been subject to substantially less regulation than other market assets. This is because more wealthy investors and companies are thought to be more able to withstand losses than regular investors. However, this has slightly changed after the recession, after which the governments started to pay more attention to private equity funds.
What about fees?
In general overview, the private equity fund fee structure is significantly similar to one of the hedge funds. For example, it adds a management fee to the performance one. Usually, the management fee is close to 2% of the investments. This way, if the fund has $100,000,000 worth of assets under its management, the fee calculated will be around $2,000,000.
The management fee covers all costs related to the administration and operation management of the fund: salaries, deals, and other administrative expenses. This fee can be collected even without any profit made ‒ everything is just like with other funds.
Also, there is a performance fee ‒ a percentage of profits made by the fund. This fee can reach up to 20% of profit and is sent to the general partner (or GP).
Performance fees are justified by the idea that they align the interests of investors and fund managers. If the fund management is successful, they will be able to defend their performance fee.
Leveraged buyouts, subordinated debt, private placement financing, and distressed debt are all possible for private equity funds. Although there are several prospects for investors, such funds are often set up as limited partnerships.
Two categories of fund participation should be understood by those who desire a better knowledge of the structure of a private equity fund. The private equity fund partners are referred to as general partners.
General partners are granted the authority to run the private equity fund and choose which investments to put in their portfolios under the terms of each fund’s structure. The acquisition of investments from limited partners is another duty of general partners. Institutions including insurance firms, pension funds, and university subsidizing are among this group of investors that also includes high-net-worth personas.
Limited partners do not participate in decisions made about investments. The precise investments that will be part of the fund are unclear at the moment funding is collected. If limited partners are unhappy with the portfolio manager or the fund itself, they may opt not to make any more investments in it.
What is a limited partnership agreement?
Institutional and private investors agree to particular investment details provided in a limited partnership agreement when a fund obtains money. The risk to each category of participants in this pact is what sets them apart. Limited partners may be held accountable for their whole investment in the fund up to that amount. Conversely, general partners are subject to the market, which means they are responsible for any debts or commitments the fund may have if it loses all of its finances.
There is also a term named “duration of the fund” ‒ it is a measure that is also described in the limited partnership agreement. private equity funds typically have a fixed lifespan of 10 years and include five stages of this life cycle:
- the creation and organization;
- the phase of raising money;
- the time when deals are found and invested in;
- the stage of managing a portfolio which lasts around five years, with the possibility of an additional year;
- the process of selling existing interests through trade sales, secondary markets, or initial public offerings.
With a limited partnership agreement, exits from deals are also defined: an exit has to be done in a limited time ‒ for example, after an initial public offering is over.
The return on investment as well as the expenses of completing operations with the fund are perhaps the two most crucial elements of any fund’s limited partnership agreement. General partners furthermore earn a management fee on top of the decision powers.
Traditionally, the limited partnership agreement specifies management costs for the fund’s general partners. Private equity funds frequently charge an annual fee of 2% of invested money to cover firm wages, deal hunting, legal fees, data and research expenses, marketing expenses, and other variable and fixed expenses.
Additionally, private equity firms get a carry ‒ this is a performance fee typically 20% of the fund’s excess gross earnings.
Due to the fund’s capacity to assist in managing and mitigating business governance and management operations that might adversely affect a public business, investors are often prepared to pay these fees.
Restrictions and limitations
The limited partnership agreement also limits the kinds of investments that general partners may be permitted to assess. These limitations usually relate to the type of business, the size of the organization, the need for diversification, and the geography of prospective acquisition targets.
Additionally, any deal that general partners finance can only get a certain amount of funding from the fund. According to these conditions, the fund is required to borrow the remaining money from banks, which can lend at various multiples of cash flow ‒ this can be used to assess the viability of proposed projects.
Limited partners must restrict possible funding to a single deal since bundling several stakes enhances general partners’ motivation structure. If a previous or upcoming deal underperforms or becomes bad, investing in numerous firms exposes general partners to risk and may diminish carry.
Limited partners do not, however, have veto power over specific investments. This is significant because, especially in the early phases of discovering and supporting firms, limited partners, who make up a more significant portion of the fund than general ones, sometimes oppose certain investments because of governance issues. The benefits of the merging fund investments may be diminished by several company vetoes.