When attempting to land a position with a private equity firm, it is key that a candidate has a general understanding of the structure of private equity firms. As a result, this discussion will attempt to summarize the typical structure of a private equity fund.
In the United States, private equity firms usually take the form of limited partnerships or limited liability companies (LLCs). In general, these structures limit an investor’s losses to their initial investment and also escape corporate double taxation. With respect to limited partnerships, the fund is managed by a general partner, and for LLCs, the fund is managed by the managing directors. The general partner or managing directors design and manage the fund and select and advise the investments.
The time line starts with the general partner or managing directors getting commitments from investors at the beginning of the fund. Then the fund gives “capital calls” to its investors over the initial five years, which is referred to as the commitment period. The expected life of a fund is typically seven to ten years, with an option to extend the life of the fund up to five more years.
The general partner or managing directors can receive compensation in three principle ways. First, the general partner or managing directors have their own capital invested in the portfolio companies, which earns a return. This is typically required, as it ensures that the sponsor’s interests are in line with those of the limited partners. In addition, the general partner or managing directors typically receive a management fee and incentive fee.
The management fee is typically 1.5% to 3.0% and is based upon the committed capital, not just funds invested in portfolio companies. This management fee may decline over time due to the fact that the manager’s work may decline over time.
The incentive fee, also called carried interest, is the share of the returns, typically around 20%, that is paid to the manager after the fund has exited its investments and returned the investor’s capital. Typically a minimum required return, or hurdle rate, has been paid on the cash from the outside investors.
While this model may be modified depending on the jurisdiction, in general all private equity firms possess the following qualities (i) the individuals or entities that provide capital to the fund benefit from the fact that they are only liable for their investment and (ii) the interest of the fund and the capital sources must be aligned; which typically means that the profits of each are linked.