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Private Equity, Private Markets

Private Equity Demystified, Part 2

How are Private Equity Funds Structured? Although the history of modern private equity investments dates back to the early 20th century, they only really gained significance in the 1980s.

Although the history of modern private equity investments dates back to the early 20th century, they only really gained significance in the 1980s. During this time, technology companies in the USA received a much-needed boost through venture capital.

Some of today’s leading companies, such as Apple and Google, were able to finance themselves initially with private equity (PE). This gave them more time for solid development because there was no need to seek investments in the fast-paced public market.

Historically, PE funds have generated higher returns than comparable funds in the public market, but they were only accessible to institutional or semi-professional investors. This was not only due to regulatory hurdles but also to the minimum investment of 200,000 Euros. These hurdles are now falling with the ELTIF 2.0, which allows private investors access to the private markets.

The structures of PE funds differ in some respects from those of their counterparts in the public capital market, but are very similar within the industry.


Basics of a Private Equity Fund

Private equity funds are typically closed-end funds. Through these funds, investors can invest in private companies and acquire equity stakes through various forms of financing (direct investments, loans, debt acquisition, etc.).

Sometimes PE funds also acquire shares in publicly listed companies to take them private again and restructure the company. After a few years, the fund sells its stakes again, e. g. through an IPO or to other investment firms.

While the investment objectives vary depending on the PE fund, their structure is usually very similar. This is regulated in the so-called “Limited Partnership Agreement” (LPA), which is the underlying fund contract between the issuer of the fund (usually asset managers) and the investors.


Partners and Responsibilities

Basically, private equity funds have two parties involved with different functions:

  • Fund issuers and, in some cases, supporting asset managers of a PE fund are called General Partners (GP). GP manage the PE fund and make the investment decisions regarding the invested portfolio. Additionally, GPs are responsible for calling the capital commitments from investors.
  • These investors are called Limited Partners (LP) of a PE fund. LPs are typically institutional investors such as insurance companies, pension funds of large industrial and commercial enterprises, as well as other asset managers and semi-professional investors such as family offices and (ultra-)high-net-worth individuals. In the future, it is expected that more and more private investors will take a significant share with with the educated advise of financial wealth advisors, banks, and family offices.

An important difference between GPs and LPs lies in the risk: LPs are liable up to the full amount of their capital invested in the fund. GPs, on the other hand, are fully liable to the market, which means they are responsible for all debts or obligations of the fund should it lose everything and its account become negative.


Limited Partnership Agreement – The Contract Between Issuer and Investors

Before a fund, i.e., the GP, collects money, the investors, the LPs, agree to the investment conditions specified in the Limited Partnership Agreement (LPA).

The LPA also states the duration for which the fund is established and the money invested by the LPs is accordingly bound. PE funds usually have a fixed term of eight to ten years, consisting of five different phases:

  • Organization and formation
  • Capital raising phase, which typically lasts about twelve months
  • Deal sourcing and initial investments
  • Portfolio management for usually about five years, with a possible extension of one to two years
  • Exit from existing investments through IPOs or share sales


Fees Consist of Management and Performance Components

Perhaps the most important components of any fund LPA are the expected return and the costs, which consist of management and performance fees. The latter are tied to the return.

  • The management fees usually amount to about 2% per year of the invested capital. So, if a private equity firm has set up a fund of 500 million euros, it would receive 10 million euros annually to cover expenses. Over the course of a ten-year fund cycle, the PE firm would thus collect 100 million euros in fees.
  • In addition, there is the performance fee, the so-called “carry,” which traditionally amounts to up to 20% of the fund’s profits above a predetermined return. Since these are so-called “excess profits,” both sides benefit.


The Investment Framework is Also Regulated in the LPA

The LPA also regulates the fund’s target direction regarding possible investments. This investment framework usually includes the industry sector, company size, diversification requirements, as well as the location of potential acquisition targets. Moreover, GPs are only allowed to invest a certain amount of the fund in each company they finance.

However, the fund issuer, along with its fund managers, ultimately determines the target investments, which they undertake after carefully conducted investment processes (including due diligence, investment committee, intensive competition as well as market observation).


Consider Well Before Binding Yourself

Private equity firms and funds offer unique investment opportunities. But here too, investment advisors and their clients should understand the structure of these PE funds before investing and be aware of the fund’s goals, including the investment duration, all management and performance fees, and the associated liability (risk). Then nothing stands in the way of a well-informed portfolio diversification with private market funds.