Top tips on how to structure a private equity fund

What is a private equity fund? 

A private equity fund is an investment vehicle managed by a professional fund manager that pools capital from multiple investors which is then invested in private companies at various stages of their development, in line with the fund’s investment strategy. Private equity funds are typically close-ended vehicles which are not listed on public exchanges.  

Private equity managers tend to take an ‘active management’ approach to working with the management teams of investee companies to enhance business value before selling or exiting the investment. In comparison, shareholders (including fund managers) in public companies generally take a passive approach to investing. 

Partners and responsibilities 

Private equity funds are usually structured as a limited partnership. Here we describe the different roles involved. 

General partners 

The private equity firm managing the fund is known as the General Partner (or GP). It manages the day-to-day operations of the private equity fund and is actively involved in the decision-making process from sourcing, evaluating and executing investment opportunities, to selecting portfolio companies, due diligence and overseeing the implementation of the overall fund strategy. The GP is responsible for raising capital from investors (limited partners (LPs)), investing that capital in accordance with the fund strategy, working with management teams to drive growth/value and managing the sale of those assets at the most opportune time. Exit proceeds are distributed to investors when assets are sold, all the way through to the eventual wind up of the fund. 

Limited partners 

LPs are the investors in the private equity fund, providing the capital required to execute the fund strategy. Limited partners aren’t involved in the day-to-day management of the fund’s operations but entrust the fund manager to invest their capital and generate a return over an agreed period. Limited Partners can include pension funds, insurance companies, sovereign wealth funds, local government authorities, family offices, and high net worth investors. 

Feeder vehicles 

A feeder vehicle is a structure used by private equity funds with its purpose being to aggregate capital from various investors due to tax/currency/size requirements and then pool it into a larger investment fund or vehicle. 

Portfolio companies 

These are the underlying portfolio companies that the private equity fund invests in. The GP works closely with these companies to enhance value and generate returns for investors over a target investment period. 

Fees 

The fees are generally dependent on a number of factors: the fund size, the fund strategy, prevailing market norms, past performance of the manager, incentives for investors coming into the fund first and early closes. A fee structure should reflect an alignment of interests between fund managers and investors and is divided into the following categories: 

Management fees

These fees usually range between 1% and 2% per annum and are used to cover the operational expenses of the fund manager. 

Carried interest

Carried interest is the performance fee that fund managers receive as a share of the profits generated from the fund’s investments. A typical fee structure would involve the first (typically) 8% of profit being returned to investors (known as the hurdle) with anything excess being split between investors and the fund manager. Sometimes there will be a ‘catch up’ where returns over the hurdle rate flow 100% to the manager so that, in the end, total profits are split 80%/20% investors/manager. 

Raising capital  

Bringing investors on board is a crucial aspect and to do so, the private equity fund manager needs to develop a compelling investment pitch to attract them. This tends to include the following: 

• The fund’s objectives and strategy 
• The investment team and track record 
• Deal origination 
• Due diligence and investment process 
• Management and performance fees 

• Portfolio and pipeline 

Private equity fund strategies 

Growth Capital 

This is where a company has identified opportunities to scale and requires funds to execute its growth strategy which may be organic and/or acquisitive for example, a company may seek growth capital to access new markets. 

Preferred Equity 

Here, the fund manager provides a financing package where a large proportion is in the form of debt instruments typically with no other third-party senior debt in the company. Whilst the potential returns tend to be lower compared to a leveraged buy-out, the risk is also lower due to the prior ranking instruments and absence of bank debt.  

Distressed/Turnaround Equity 

The fund manager has identified the companies which are in a distressed financial situation due to factors such as a volatile economic environment, mismanagement, over-gearing, or the distress of a parent/group. These assets can often be purchased at low valuations, restructured and stabilised allowing growth to return and value to recover rapidly. The risk associated with these types of investment are high but so are the potential returns. This strategy requires a highly experienced turnaround manager with a track record of managing these challenging investments. 

Leveraged buyouts (LBOs) 

A leveraged buyout (LBO) is a financial transaction in which a company is acquired using a significant amount of borrowed funds, often with the assets of the company being used as collateral for the loans. The purpose is typically to take a controlling interest in a company while minimising the amount of capital invested by the acquiring party. 

Private equity fund timeline 

The timeline of a fund varies depending on several factors, including the investment strategy, target industries, and specific investment opportunities. Whilst public equity funds intend to be evergreen, private equity funds tend to be close-ended with a finite term, typically 10 years. Here is an overview of the typical timeline: 

Fund formation: This phase, which occurs prior to the fund launch, is where the partnership is formed, the fund’s strategy is established, and the fund manager seeks commitments from investors. 

Investment period: The fund begins to make investments and works closely with management teams to add value and maximise potential investor returns. This tends to be during years 1 to 5 with capital drawn over time from LPs as each investment is completed. 

Harvesting: In this phase, the fund manager arranges exits from the portfolio companies and capital is distributed back to investors. Some portfolio companies may exit quickly but in general distributions to investors will start around year 4/5 with drawn capital back (i.e. investors fully de-risked) by year 6/7 and profits distributed years 8/9. As distributions can start before the fund is fully drawn, investors often will not have to part with 100% of their commitment.  

Private equity fund exit strategies 

Private equity firms employ various exit strategies to generate returns on their investments. The choice of exit strategy depends on factors such as market conditions, the performance of the portfolio company, and the overall investment objectives. Here are some common exit strategies in private equity: 

Initial Public Offering (IPO): Taking a portfolio company public through an IPO involves selling shares to the public on a stock exchange. This strategy allows the private equity firm to monetise its investment and provide liquidity. However, IPOs are subject to market conditions, and the company needs to meet regulatory and financial requirements. Often the private equity seller will be subject to a lock-in period so may not be able to realise its proceeds in full at the IPO date. 

Strategic Sale or Trade Sale: This exit strategy involves selling the portfolio company to another company. The acquiring company may be interested in the synergies, market share, or technology that the portfolio company brings.  

Secondary Sale: Private equity firms can sell their ownership stakes in a portfolio company to another private equity firm. This can be a partial or complete sale, and it allows the selling firm to exit its investment while allowing the acquiring private equity firm to take over. 

Recapitalisation: In a recapitalisation, the private equity firm, along with the portfolio company's management, may opt to take on additional debt to pay a special dividend or repurchase shares. This provides liquidity to the private equity firm while allowing it to retain an ownership stake in the company. 

Management Buyout (MBO): In an MBO, the current management team of the portfolio company buys out the ownership stake held by the private equity firm. This strategy is often chosen when the management team believes it can continue to grow and improve the company independently.