The OfficeHours Guide to Private Equity Part 2

In Part 1 of the OfficeHours series on private equity, we touched on why private equity exists as a financial instrument: through the use of leverage, PE firms (also known as “financial sponsors”) can magnify their returns, invest in more companies, and generate more money for investors. We will now review how PE funds are structured and how they make money.

GP’s and LP’s

How do financial sponsors have money to invest in the first place? PE funds are run by General Partners, or GP’s. These are experienced investors who raise funds and invest these funds into companies in order to generate a return for the people who gave them money. The people who gave these GP’s money are called Limited Partners, or LP’s. LP’s include anyone with enough money to invest millions of dollars, including high net worth individuals, endowments, pension funds, and other institutional investors. The minimum investment required by most PE funds tends to be at least a few million dollars.

LP’s are the ultimate client of PE funds. If the fund does not generate a high enough return for its LP’s, then the LP’s could withdraw their money or decide not to invest in the next fund. LP’s invest in the private equity asset class for diversification purposes and also to beat the market. Most top quartile PE funds target a 20% annual return over 5 years (equivalent to 2.5x your money) which is more than double what the S&P has returned over time.

2 and 20 Fee Structure

What’s in it for the GP’s? GP’s usually get paid on a “2 and 20” model, which means they get paid 2% management fees of the fund size every year and 20% of the returns they generate. So, for a single GP that runs a $100 million fund, the management fees are $2 million a year to pay his or herself and cover fund expenses. Hypothetically, if the fund returns 3x over its lifetime, the GP also gets paid 20% of the $200 million the fund returned in performance fees, or $40 million.

These performance fees are paid out to anyone at the fund that has a share of the profits in the fund, which is called carried interest. Carry is usually awarded at the senior associate or VP levels, though the partners at the fund have most of the carry. You can see how investors at top performing PE funds can quickly earn far more than peers in investment banking! Note that some of the best PE funds might even charge higher rates, while newer funds might charge lower rates. 1 and 20, 1.5 and 30, and even 2 and 30 are possible fee structures for PE firms.

But making a 3x return on a fund isn’t easy. What are the major things PE firms do to maximize their change of success? One key feature of private equity is control.

Unlike their VC and hedge fund counterparts, PE firms have majority ownership in the companies they acquire. This controlling stake allows financial sponsors to make outright decisions about the company. On the other hand, VC’s and hedge funds can usually only influence but not control decision making in their investments.

Now that you know how PE funds make money, we will dive into specific levers PE funds can use to increase their returns in the next chapter.

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