A private equity fund’s structure sounds like legal plumbing, but it decides who gets paid, when, and why. Almost every PE fund is built on the same skeleton: a limited partnership with two parties – the general partner (GP) who manages the money, and the limited partners (LPs) who provide it. Once you understand how the GP/LP relationship, the management fee, the carried interest and the waterfall fit together, the rest is country-specific detail.
From a legal perspective, a private equity fund can look like a complicated beast. 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 most private equity funds tend to have a similar premise; that is, to provide a vehicle whereby a private equity manager can raise capital and facilitate investment into investees.
Before going into how private equity funds are structured, we first have to understand what objectives private equity fund managers are trying to achieve. 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 gains taxing on carried interest. In the U.S., this is at a maximum of 15%.
The Entities: GPs, LPs and the Limited Partnership
Limited partners (“LPs”) are the outside investors that provide the bulk of the private equity fund’s capital – pension funds, endowments, family offices and funds of funds. The general partner (“GP”) is the professional investor that manages the fund and deploys the capital. In most cases, the GP also provides a sliver of the fund’s capital, typically 1-5%, to show skin in the game. The fund itself is usually a limited partnership (or a stack of them, onshore and offshore), governed by a limited partnership agreement (LPA) that every LP signs. A variation worth knowing is the search fund, where the GP raises capital in two rounds, first to find a suitable acquisition target and then to buy it. Often, there is a separate entity called the management company which employs the investment professionals. This is usually done in cases where the fund and the GP are offshore for tax and privacy reasons.
In exchange for the GP’s expertise and efforts in investing the capital, the fund pays them a management fee; this is generally between 1.5% to 2% per year of the fund’s committed capital. Provided return hurdles are met, GPs are also entitled to carried interest – that is a percentage (usually 20%) of profits generated. This is where the term 2 and 20 comes from, though the percentages are generally lower at larger fund sizes.
GP/LP Economics at a Glance
| Term | Typical range |
|---|---|
| Management fee | 1.5-2% p.a. of committed capital (often stepping down to invested capital after the investment period) |
| Carried interest | 20% of profits above the hurdle |
| Hurdle (preferred return) | ~8% p.a. to LPs before carry kicks in |
| GP commitment | 1-5% of total fund size |
| Fund life | 10 years, plus one or two 1-year extensions |
| Investment period | First 4-6 years of the fund’s life |
The Waterfall: How the Money Actually Flows
The distribution waterfall is the part of the LPA that turns fund structure into money. Most PE funds use a European-style waterfall, where the GP’s carry is calculated on whole-fund profits rather than deal by deal. The order matters more than the percentages:
- Return of capital: LPs first get back everything they have contributed, including amounts used to pay fees.
- Preferred return: LPs then receive the hurdle, typically an 8% annual return on their money.
- GP catch-up: the GP now takes most or all of the next slice of profits until it has received its full 20% share of profits so far.
- The split: everything after that is divided 80/20 – 80% to the LPs, 20% to the GP as carried interest.
A worked example. A $100m fund returns $200m in total distributions over its life – so $100m of profit on $100m contributed. First, the LPs get their $100m back. Say the 8% preferred return has accrued to $60m over the years; that goes to the LPs next, taking them to $160m. The GP then catches up: it takes $15m, which is 20% of the $75m distributed above returned capital so far. The last $25m splits 80/20 – $20m to the LPs, $5m to the GP. Final tally: the LPs receive $180m and the GP $20m, exactly 20% of the $100m profit. That $20m is the carried interest, and it is why the GP cares about where the fund sits in its life cycle long before exit.
Capital Calls
In a committed capital fund, the LPs have signed a formal partnership agreement (limited partnership agreement or LPA) and are legally bound 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, including to cover management fees. 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 2-4 weeks). The difference between the total commitment amount and the capital called to date is referred to as the “un-drawn obligation” by the LP.
Defaults
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. These consequences are usually enshrined upfront in the limited partnership agreement. 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. GPs generally do not want to burn bridges with LPs who will be the likely providers of capital for future funds.
What You Should Know
As a business owner/entrepreneur looking to sell or raise funds 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 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.
It is also worth understanding the tools the GP will bring to the table once they invest – preferences, ratchets, earn-outs – which I break down in the post on deal structuring.
Fund Structure FAQ
What is the difference between a GP and an LP?
The general partner (GP) manages the fund: it finds deals, makes investment decisions and sits on portfolio company boards. The limited partners (LPs) are the passive investors who provide most of the capital. LPs have limited liability – they can lose what they committed, nothing more – and no say in day-to-day decisions.
Why are private equity funds structured as limited partnerships?
A limited partnership is a flow-through entity for tax purposes, so profits are taxed once at the investor level rather than at both the fund and investor level. It also lets the LPA hard-wire the economics: management fees, the hurdle, catch-up and carried interest all live in that one document.
What is dry powder?
Dry powder is the capital a fund has raised but not yet deployed – committed capital minus capital already called and invested. It tells you whether a fund can actually write a check for your business today.
How long does a private equity fund last?
The legal documents usually say ten years, with options to extend by one or two years. In practice the clock starts when real money is raised and ends when the last asset is sold, so a fund’s true life runs 12-15 years.