Nov '24 • Private Equity
Private Equity Fund Structure Guide
Simplified Structure of a Private Equity Fund
Private equity funds, from a legal perspective, can appear intricate, but their basic structure is straightforward once explained. While country-specific laws can add complexity, most private equity funds operate on a similar principle: to serve as a vehicle allowing managers to raise capital for investment purposes.
Key Objectives of Fund Structure
Private equity managers aim to create a fund structure that ensures tax efficiency, specifically through a flow-through entity to prevent double taxation. This helps avoid taxes at both the company and personal levels. Additionally, these funds often seek to qualify for capital gains taxing on carried interest, which in the U.S. is capped at 15%.
Main Entities in a Private Equity Fund
- Limited Partners (LPs): The outside investors providing the majority of the fund’s capital.
- General Partners (GPs): Professional investors who manage and deploy the capital, often contributing a smaller share to show alignment with LPs' interests.
- Management Company: Typically a separate entity employing investment professionals, used when funds and GPs are offshore for tax or privacy considerations.
GPs receive management fees, generally 1.5% to 2% annually of the fund's committed capital. If return benchmarks are met, they also receive carried interest, typically 20% of profits, reflected in the "2 and 20" model.
Capital Calls and Commitments
In committed capital funds, LPs sign a partnership agreement obligating them to provide capital. Funds are not transferred upon signing but instead through "capital calls," which GPs issue as needed, often quarterly. The "un-drawn obligation" refers to the difference between the total commitment and the capital called so far.
Consequences of Capital Call Defaults
While defaults are rare, they carry serious financial and reputational consequences for LPs. Penalties might include forfeiting fund interests or selling stakes at a discount. This impacts future investment opportunities and relationships with GPs. During economic challenges, LPs and GPs often negotiate solutions that work for both parties to maintain relationships.
Considerations for Business Owners/Entrepreneurs
When engaging with a private equity firm, entrepreneurs usually do not need to know who the LPs are due to the low risk of LP defaults. Instead, focus on:
- Total Fund Size: Align the size of your company with the appropriate fund. A $20-$30 million business wouldn't match with a $5 billion fund, while a $400-$600 million company should not target a $100 million fund. Middle-market funds generally aim for 5 to 10 investments per fund for optimal performance.
- Fund “Dry Powder”: This is the total fund size minus deployed capital, indicating the firm’s capability to invest. Private equity firms hold back a portion of capital, usually about 20%, for fees, growth capital, or add-on acquisitions. GPs might also source additional capital or be fundraising, which could impact their focus on new deals.
Business owners who have experienced selling to private equity firms are encouraged to share insights on key questions that should be asked during early discussions with GPs.
0
0 comments
Private Equity Fund Structure Guide
