The formulas, tricks and trade secrets of Private Equity
Private Equity Fund Structure
From a legal perspective, a private equity fund can look like a complicated beast (see left). However, the structure of a private equity fund is quite easy to understand once properly explained. Additional complexity can arise from country-specific legislation, but all funds tend to have a similar premise; that is, to provide a vehicle whereby a private equity manager can facilitate investment into investees.
A few objectives lead to the structure being what it is. One major objective is to provide a flow-through entity for taxation purposes. This is to circumvent double-taxation, which leads to investors being taxed at the company level and the personal level if not handled correctly. Another major objective is to qualify for capital gain taxing on carried interest. In the U.S., this is at a maximum of 15%.
Industry parlance often includes references to limited partners (the investors) and the general partner (the manager). The limited partners are simply the investors who provide money to take stakes in the investees (portfolio businesses). The general partner is the firm (and its staff), which manages the limited partnership (the investment vehicle) and facilitates investments into the investees. The legal theory is that the limited partners have limited liability, whereas the general partner does not.
The second arrow between the general partner and the limited partnership represents the general partner’s financial interest in the fund. This may refer to a direct investment of the fund, but it mostly refers to the right to carried interest. Another article talks about “carry” in more detail. The partnership deed outlines the terms such as fees and carry.
As we previously discussed, limited partners (“LPs”) are the outside investors that provide capital to the private equity fund structure. The general partners (“GPs”) are the professional investors who manage the firm and deploy the capital. In acommitted capital fund, the LPs have signed a formal partnership agreement and are legally committed to provide the capital. It is important to understand that the LPs do not typically transfer their capital at the time of signing the agreement. Most GPs make “capital calls” on a quarterly or on an as needed basis. A capital call is a formal notification from the GP to the LP indicating that a specific amount of money is to be transferred to the private equity firm within a certain time period (usually 30 days). The difference between the total commitment amount and the capital called to date is refereed to as the “un-drawn obligation” by the LP.
While the GPs do not have the funds sitting in their bank account, it is very unusual for an LP to default on a capital call. First, an event of default on a capital call would have severe financial consequences for the LP. A default can result in the LP forfeiting all or some of their interest in the fund. Or the LP may be required to sell their interest to a third party or another non-defaulting LP at a significant discount. In addition to financial consequences, a default of a capital call will damage the LP’s relationship with the GP and they most likely will not be able to invest in subsequent funds that the GP might elect to raise. A default also hurts the LP’s reputation within the industry. Other GPs, particularly the best fund managers and the funds the LP wants to invest in, would be hesitant to work with a LP that has a history of defaulting on a previous capital call.
In periods of significant economic volatility or cash strain, the LPs will work with the GPs to structure something that will work for both parties. The article “Cash-Poor LPs Face Capital-Call Pressure” by Private Equity Insider has a great discussion on the topic when, during the recent financial crisis, LPs were finding themselves with very limited cash to meet their un-drawn obligations to private equity funds.
As a business owner/entrepreneur looking to sell or raise capital from a private equity firm, you probably are not going to know who the LPs are in a committed capital fund. Given the extremely low probability of an LP default, knowing the LPs is usually not important. As a seller to a committed capital fund, there are two important GP-LP structural considerations:
Total Fund Structure Size: Total fund size gives you an indication of whether the fund is appropriate to approach for the acquisition of your company. If your company is worth $20 million to $30 million, it would not make much sense to approach a firm that is managing a $5 billion fund. On the other hand, if your company was worth $400-$600 million, you should not be approaching a firm with a $100 million fund. Middle market private equity funds will generally make between 5 and 10 investments with any one fund. Any fewer than 5 and they risk having the overall fund performance be too highly concentrated. Any more than 10 investments creates significant management challenges to oversee the portfolio companies in which they have invested. As a side note, it can make sense for a large fund to look at a small company if it was making an “add-on acquisition” (i.e. one of the private equity fund’s portfolio companies making an acquisition). In this case though, the transaction is more similar to selling to a strategic buyer than a financial buyer.
Fund “Dry Powder”: This refers to a fund’s total size less any capital the firm has already deployed. It’s an indicator of whether the fund has the ability to write the check to invest in or acquire your company. Remember that private equity firms usually will not deploy 100% of their capital. A portion, typically 20%, is held back to pay management fees. Additionally, firms will retain capital to support add-on acquisitions, provide additional growth capital or other support to their existing portfolio companies. Firms do sometimes have the ability to draw on additional 3rd party capital sources for a deal or they might be out fund raising, but knowing how much dry powder they have gives you a clear picture of whether they are in a position to close a deal. If the GPs are out raising and marketing their next fund, it may take away from their time to work with you and/or the ability to commit to you on the transaction in a timely manner.
Those of you who have sold businesses to private equity firms, please share any additional thoughts on the key questions business owners should ask a the private equity firm structure GP during the getting to know one another stages of the M&A deal process.
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