Part 6: PE Fund Structure and Fees

Thrive Blog Series: Private Equity is not a Black Box

Generally, LPs determine that they want a particular percentage of their funds allocated in private equity. Once they have this target, they then choose the GPs to invest their money for them. This process has gotten more and more competitive over the years. When GPs are ready to raise their next fund, they often announce they have begun “fundraising”. They hire an Investor Relations/Fundraising professional. They go on roadshows to meet with their existing LPs as well as new ones. They trot out their performance record, their differentiators / secret sauce, their team, and they put their best foot forward. Today, GPs compete fiercely to attract LP dollars and their track record is their make or break. If their last fund did well, chances are, they will be able to attract additional dollars for their next fund.

Ideally, their original LP investors return to invest and, as a they grow and generate successful returns, they strive to attract higher value LPs. You have the gold star LPs (well-known foundations, large, powerful endowment gatekeepers, think Ivy League, highly regarded sovereign funds, etc). Not everyone starts there, so they start with the smaller less well-known funds they are able to attract and as they perform, they “upgrade” their investors. You always want to see a repeat of the earlier investors though. Total turnover is not a good sign. 

At this point, you have a GP who has a particular strategy defined, they attract their LPs who agree to commit money to the fund. Together, they agree on what the GPs will invest in - industry(ies), geography, situation (management buy outs, corporate carve outs, first money in, distressed etc), and they agree on approach - is this a buy and build fund (go out and make lots of acquisitions to “bolt-on” to a platform company) or is it a growth fund (earlier stage higher risk), or is it a real estate fund etc? They also agree up front if they are going to take majority control positions or if they are open to taking minority positions. Generally the private equity firms we work with are doing majority control with the occasional minority stake. 

Once the fund details have been defined, they agree on terms and conditions. Historically, GPs have taken 2% of the fund amount committed as a management fee to cover their overhead like salaries, bonuses, office space, consultants etc. That number has come into contention over the last number of years. LPs are driving much harder bargains requiring the GPs to meet certain milestones if they want that number. Some are even negotiating for less than 2%. The days of private equity fat cats collecting their fees for little effort are no longer. But of course, they are not working as hard as they do to take home just 2%. The other critical number in private equity is 20%. Generally, the LPs receive 80% of the returns generated and the PE GPs take home 20% of the returns, in their pockets. AND, despite the best efforts of some legislators, that 20% is still only taxed at a Capital Gains rate of ~20% (assuming they hold their investments for 3 years - they just dodged a bullet trying to increase that to a 5 year hold), so they only have to pay ~20% instead of income tax rate of closer to 35%+. Being a GP can be very lucrative. The LPs can make great returns for their shareholders/stakeholders, and the GPs make a buck in the meantime. IF they do well. What happens if they don’t? 

Once upon a time I was married to someone in private equity whose firm was not performing. That firm had to do what are called capital calls. When a fund does not meet its target objectives for returns, the LPs can “call capital” from the GPs, aka, the GPs who manage the fund have to write checks (including personal checks!) to the LPs to pay back their losses. I will never forget the feeling I had writing personal checks from my account to pay for their losses. More importantly, their mismanagement impacted the companies they invested in, bringing them to their knees, losing jobs for the employees and the LPs’ stakeholders. Real retirees lost income. I personally have only ever worked for very successful private equity firms. I’ve worked with one firm for over a decade that raised $300MM for its first fund and has grown to targeting $3B+ for Fund VI. Watching their growth and seeing their very real impact on thousands of people’s lives re: both their portfolio company employees and the positive impacts their products and services have had has been more than awesome. They are a case study in how to do this right. 

Another tidbit worth mentioning is the backward logic that when a GP raises money for its next fund, it says it has “closed”. It has a first close, then a second and maybe other closes and ultimately it’s complete. The GP soft circles the early investors who commit their money to the fund. After they get a large commitment, they will often say they have had a first close. They will continue fundraising to bring in the rest of the targeted money, but it allows them to start investing from that fund. Sometimes LPs will commit dependent on other LPs following with additional investment. There are varying levels of commitment. When you hear a fund closed, it doesn’t mean it shut down, it means it raised more money!

Another interesting fact is that the LP investors do not send checks to the GPs for their whole commitment up front to sit in an account somewhere. They pay the 2% management fee, but then as the GP buys new companies, the LPs write checks for those acquisitions commensurate with their investment commitment. As each company then needs additional funds for their own acquisitions, there are capital calls to support such activity. In this case, the capital calls are expected and a positive thing.

Thrive Blog Series: Private Equity is Not a Black Box

PART 1 - Introduction https://www.thriveresources.com/news/2022/4/19/private-equity-is-not-a-black-box 

PART 2 - The Secret Sauce of Private Equity https://www.thriveresources.com/news/2022/4/6/thrive-resources-blog-series-private-equity-is-not-a-black-box 

PART 3 - PE Acquisition Targeting https://www.thriveresources.com/news/2022/5/18/part-3-how-pes-target-acquisitions 

PART 4 - EBITDA https://www.thriveresources.com/news/2022/5/31/part-4-the-baea-be-all-end-all-ebitda

PART 5 - The Private Equity Spectrum https://www.thriveresources.com/news/2022/6/7/part-5-the-private-equity-spectrum