Limited Partners (LP) typically made up of endowment funds, pension funds, high net worth individuals, institutional investors and sovereign wealth funds provide 99% of the capital in a private equity fund. The remaining 1% of the capital is invested by the General Partner (GP). LPs have limited liability, while GPs have full liability. The GPs are responsible for investing the fund's capital in public and private companies, manage the portfolio of investments and execute the exit strategy to sell investments in the future for sizeable returns of which they keep typically 20% and return 80% to the LPs. GPs also charge a 2% annual management fee to manage the assets on behalf of the LPs.
Private Equity Funds Raising
A successful Private Equity firm generally has more than one fund. A typical fund in a private equity firm has a total lifespan of approximately 10 years. Private Equity firms are generally required to invest each respective fund’s capital within a period of about 5-7 years and then usually it takes another 5-7 years to sell (exit) the investments. PE firms typically use about 90% of the capital available in a fund to make new investments, and reserve about 10% for capital to be used by their portfolio companies (bolt-on acquisitions, turnaround unsuccessful investments, working capital requirements etc.).
Funds can span different sectors, risk appetites and investment horizons, but firms often specialize in one area (or a couple of related areas) and focus on growing their expertise and returns there. For example: an infrastructure fund will focus on making investments into companies that build, own and maintain infrastructure assets in different sectors - telecommunications, energy etc.
Private Equity firms engage in a continuous cycle of raising capital. As PE firms continue to invest capital from one fund, they will be seeking commitments from investors to build their next fund. Conversely, if a PE firm does not have a strong investment track record, it may be forced to unwind its operations if it is unable to raise additional capital through raising new investment funds.
Here’s an example: a private equity firm may raise its first fund, which it could call 'Fund 1'. Fund 1’s committed capital is invested over time to create a portfolio of investments. The capital is returned to the limited partners when the investment in the different portfolio companies are exited/sold over time. Therefore, as a PE firm nearing the end of Fund 1 will need to raise a new fund from new and existing limited partners to continue its operations.
Once 50% of Fund 1 has been invested to acquire companies, the PE firm will most likely need to make preparations to start fundraising for Fund 2. If the PE firm is able to show an impressive track record of returns from Fund 1, it should be able to raise larger sequential funds (starting with Fund 2). But if Fund 1 is not performing well, it may struggle to raise capital for Fund 2, which will possibly jeopardize the firm’s ability to continue operations.
Therefore, the success of a private equity firm is in its ability to make the right investment and generate sufficient returns for its Limited Partners so that they can continue to roll out more funds in the future and continue to make investments and returns.
Performance Fees / Incentives Fee / Carried Interest / Carry
Private Equity firms have two channels of income strea:
Charge an annual management fee of typically 2% to manage the assets into which the firm has invested its LPs capital
When exiting an investment, the returns are split 80:20 between the LP:GP
The annual management fee and the proportion split of the returns on exit may vary from one private equity firm to another. But, typically they charge 2% management fee and split the profits 80:20 on exit.
There is also typically a hurdle rate (an annual required rate of return) that the GPs have to achieve before performance fees can be split with them. This is in place to motivate the GPs to generate large returns and therefore, aligns the incentives between the LPs and the GPs.
Just to put some numbers to bring perspective:
For a $10bn fund, the private equity firm charges $200mn of annual management fee (2% p.a)
Assume that the fund's investments are all exited in 10 years time and they were able to generate an average of 2.5x MOIC across their investments. This translates to between 9.5% to 10% annual rate of return over 10 years and a MOIC of $25bn, which includes $10bn invested capital + $15bn return on investment
Assuming the hurdle rate condition was met, the Private Equity firm takes 20% i.e. $3bn as performance fees
So, after 10 years, the private equity firm would have made $2bn in annual fees + $3bn from selling its investments. Furthermore, it will probably be on its way to rolling out Fund 2!
Management Teams
When a private equity fund invests in a private company, along with the other shareholders (if any), it may need to recruit a senior management team (SMT) to operationally run the private company. The SMT may also need to be incentivised through a Management Equity Plan (MEP) / Management Incentive Plan (MIP) so that they perform well in their operational roles of running the company.
MEP / MIP are typically structured as a function of the company's financial performance over time or through issuing equity (typically 1% - 5%) to make the management feel ownership of a part of the company. The equity issued to management may also be a different class of shares with different capital distribution clauses. This step is extremely important as the Private Equity Fund (GP) needs to align the management's incentives with theirs for the investment to be successful.
So, there are effectively two levels of alignments required:
Alignment between the LPs and the GPs
Alignment between the GPs and the SMTs
Comentários