Structure of Private Equity Funds

Private equity funds are pools of privately-managed capital, formed for the purposes of making investments in private companies. Private equity funds are typically managed by the promoter of a fund (or an affiliated party) and this manager earns a fee for performing the investment management function typically consisting of (or including) a share of the profits generated by the fund. Generally, investors in a private equity fund commit to invest a certain amount of capital when the fund is established and as the manager identifies suitable investments for the fund, these investors are required to advance the capital they have committed to invest. A private equity fund invests its capital in companies identified by the manager, which are often referred to as “portfolio companies” or “portfolio investments”.

Typical Structure

Private equity funds are typically structured as limited partnerships. The general partner of a private equity fund will normally be the promoter of a fund or an entity related to it. The general partner is the party that, at law, is responsible for the management of the business of a limited partnership and assumes all of its liabilities. Often the general partner delegates management responsibilities to another entity, referred to as the manager, that is a related party of the fund promoter and general partner and that earns the management fee to manage the investments made by the fund. The investors in a private equity fund are the limited partners of the limited partnership. Generally, limited partners are not responsible for the obligations of the limited partnership and their liability is limited to the capital contributions that they have committed to make to the limited partnership. Limited partners cannot take part in the control of the business of the limited partnership and normally cannot withdraw from their obligation to meet their capital commitment. The life cycle of a private equity fund varies, but a fund is usually established for a term of 10 years, with the general partner having an option to extend the life of the fund for up to two years if necessary to allow for an orderly wind down.

Commitments and Draw Downs

Capital contributions to pay management fees and operating expenses are usually advanced by (or “drawn down” from) limited partners periodically over the course of a fund’s life. Capital contributions to make portfolio investments are typically drawn down over an initial three to five year period known as the “commitment period”. Once the commitment period is concluded, the fund’s manager will monitor and manage investments to maximize value and realize returns over the life of the fund. Follow-on investments may require further draw downs of capital during this phase, but investments in new portfolio companies are usually prohibited. Average hold periods for private equity investments are less than five years, although the range of hold periods can be as much as 10 years.

Fees and Distributions

When portfolio investments are sold (or “realized”), a private equity fund will usually distribute investment proceeds to the fund’s limited partners. Generally, all capital realized is distributed to the limited partners until the value of the limited partners’ capital contributions has been returned to them, in addition to an amount representing a return on the limited partners’ investment (referred to as the “preferred return”). The limited partners’ preferred return is generally calculated as 6% to 8% of the fund’s invested capital per year. Once the limited partners receive their capital contributions and the preferred return, the next distributions made by the private equity fund (effectively representing the profits made by the fund) are typically allocated between the general partner and the limited partners. The general partner is usually entitled to 20% of the overall profits (an amount referred to as the “carried interest”). The order of priority in which a private equity fund makes distributions (as described above) is often referred to as the “distribution waterfall”.

The manager of the fund typically earns a management fee of 1.5% to 2.5% per year, throughout the life of the fund. Generally, the management fee paid during the commitment period, when the manager is sourcing new investments, is based on aggregate committed capital to the fund, and thereafter the fee is based on the amount of capital that is actually invested by the fund in portfolio investments. The management fee represents an expense of the fund, and is typically recouped by the limited partners before the manager is paid the carried interest. In a successful fund, the full cost to the limited partners of the services of the general partner and manager is therefore typically 20% of the total profit achieved by the fund.

As a fund approaches its termination date, its remaining portfolio positions are liquidated or, in limited circumstances, are distributed to the limited partners.

Other Commercial Terms

A private equity fund is typically governed by its limited partnership agreement, which is entered into between the general partner and the limited partner investors. Among the important terms and conditions generally found in a limited partnership agreement, in addition to those already referred to, are target investments and investment restrictions which set forth what the fund is expected and permitted to invest in, a successor fund provision which provides that the promoter and manager will not launch or manage another private equity fund until the first fund is substantially invested, the terms on which the limited partners may replace the general partner and the fund’s governance structure.

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