Private equity is usually structured as a Limited Partnership (LP) or Limited Liability Company (LLC). Under a limited partnership, there are two groups: limited and general partners. Limited partners commit to capital to be invested by the fund. They are usually accredited investors such as pension funds and insurance companies. Meanwhile, general partners are responsible for day-to-day operations, including managing funds, identifying investment opportunities, and realizing profits.
Private equity firms raise funds from limited partners and invest them, for example, by acquiring startups. They aim to make money for limited partners, usually within five to seven years. Unlike hedge funds, private equity firms invest in private rather than public securities. Some may also buy a publicly traded company to acquire a controlling stake and, therefore, make it private.
Private equity obtains compensation from management fees and incentive fees. The management fee is based on the funds the limited partner commits to invest. Meanwhile, the performance fee is based on the investment profits earned. The typical model is a 2% and 20% fee structure, namely a 2% management fee and a 20% performance fee. This percentage-based fee structure is why private equity fees are significant. The greater the funds managed and the profits earned, the more significant the compensation obtained by private equity.
What is the most common structure of private equity?
Private equity is usually structured as limited partnerships (LLPs) or limited liability companies (LLCs) rather than as corporations. Under this structure, partners incur limited losses. Investors are exposed to limited liability. Thus, they only risk the capital they have committed if something goes wrong in the investment process, such as bankruptcy and lawsuits.
Unlike public companies, investing in private equity is relatively limited and requires a significant upfront investment. For this reason, it is usually only an investment vehicle for accredited investors or qualified clients such as insurance companies and pension funds. Some wealthy individuals are other investors.
The private equity structure, in general, includes two groups, namely:
- Financial sponsors
Financial sponsors usually include general partners and management companies. A management company is a term for a private equity firm. Sometimes, we call it a sponsor. For example, when a fund has a private equity managing company, we say it is “sponsored.” Sponsors employ investment professionals to allocate capital and manage investments.
Meanwhile, general partners manage the fund and are responsible for day-to-day operations, including administration and management. They guide private equity firms to:
- Organizing and promoting capital raising for the fund
- Identifying and executing investment opportunities, including strategies such as leveraged buyouts (LBO).
- Maximizing investment value, including managing portfolio company companies after investment
- Executing an exit strategy to realize a return on investment for the funds to be redistributed to limited partners
Under a limited partnership, the investor acts as a limited partner (LP). They may be pension funds and insurance companies. Or they are wealthy individuals and other qualified investors.
Investors provide capital. Their money is pooled, managed, and invested. Long story short, they provide capital by purchasing interests in the fund’s entities. Then, the general partners use their money to invest. However, unlike general partners, limited partners are not involved in managing the fund.
How is private equity paid?
Private equity firms are paid based on the funds they manage and the profit they generate. Two primary sources of income for private equity firms:
- Management fees
- Performance fees
In addition to these two sources, in some instances, private equity may also charge a specific fee. For example, under a leveraged buyout (LBO) strategy, a private equity firm may charge a fee to arrange for the acquisition or the post-acquisition divestment of assets.
Management fees are fees charged to limited partners for managed funds. Limited partners are asked for their capital commitment when investing in private equity, which is the amount they pledge to invest in the fund. The general partner then withdraws the pledged funds over the next several years as it finds investment opportunities and until the committed capital is fully drawn and invested.
Management fees are usually calculated based on the capital they commit, not the capital they invest. And it is expressed as a percentage, usually 1%-3% of the committed capital.
With these percentage-based fees, private equity firms can earn significant revenue if they manage substantial funds. And the bigger the funds involved, the bigger their income. For example, if they managed a $1 billion committed fund and charged 1.5%, they could earn $15 million annually. Moreover, they receive this nominal regardless of their investment performance.
The performance fee is based on the return on the funds invested. It is also known as an incentive fee. The general partner usually earns it after the limited partner has recouped their initial investment.
When will this incentive fee be distributed? First, it may be based on the exit from the investment. For example, a fund invests in a startup and realizes profits by selling targets to the public through an initial public offering. Profits are then shared among the general and limited partners, in addition to a return on their initial investment.
Second, incentive fees may also be distributed based on profits earned over time. In other words, the fund may have gone through several exit strategies.
The fee size varies between funds, usually around 20%. For example, a $1 billion fund generates a 30% return or a profit of $300 million. Therefore, 20%, or $60 million, will be distributed to general partners as incentive fees, and the remaining 80%, or $240 million, will be distributed to limited partners. This 20% is known as the “carry,” “carried interest,” or “profits interest.”
Performance-based incentives have been debated in the United States. The controversy lies in whether profit sharing is considered a return on investment or a salary. While if the profit is regarded as a return on investment, the fund manager pays a lower tax rate than if it is considered salary.
2% and 20% fee structure
The 2% and 20% fee structures refer to a 2% management fee and a 20% incentive fee. In other words, private equity charges limited partners a 2% fee to manage their money and earns a 20% return on invested capital. Another variation might be a 3% and 30% fee structure, namely a 3% management fee and a 30% incentive fee.
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