How Are Private Equity Funds Structured?

Private equity funds pool capital from various investors to acquire equity stakes in private companies. They provide capital to businesses not listed on public stock exchanges, aiming to enhance their value through strategic guidance and operational improvements. The goal is to generate returns for investors, aligning interests and maximizing profitability.

Legal Framework and Key Entities

Private equity funds are most commonly structured as limited partnerships (LPs). This structure offers pass-through taxation, meaning income and losses are directly passed to investors, avoiding fund-level taxation. Investors benefit from limited liability, where potential losses are capped at their committed capital. While LPs are predominant, some funds may also utilize Limited Liability Companies (LLCs).

Within this limited partnership structure, two primary parties are defined: the General Partner (GP) and the Limited Partners (LPs). The GP serves as the fund manager, responsible for all investment decisions, fund operations, and actively managing portfolio companies. While GPs have unlimited liability for fund obligations, they often mitigate this by structuring their own entity as an LLC or corporation, limiting personal liability to that entity’s assets.

Limited Partners are investors who contribute capital to the fund. These include institutional investors such as pension funds and university endowments, wealthy individuals, and family offices. LPs have limited liability, meaning they are only responsible for losses up to their committed investment. They generally do not participate in the day-to-day management or investment decisions of the fund, serving primarily as passive capital providers trusting the GP’s expertise.

The fund, typically the limited partnership, acts as the pooling mechanism for committed capital. This entity serves as the investment vehicle through which the GP deploys capital into target companies. The Limited Partnership Agreement (LPA) outlines the partnership’s terms, defining roles, responsibilities, and financial arrangements between the GP and LPs. This agreement establishes the operational guidelines and profit-sharing mechanisms that govern the fund’s lifecycle.

Fund Operations and Investment Stages

A private equity fund commences with securing capital commitments from Limited Partners. During fundraising, which can extend for months or even up to two years, GPs solicit pledges from LPs to invest a specific amount of capital over the fund’s life. This commitment is a promise to provide funds when requested, rather than an immediate cash transfer, giving LPs flexibility in managing their liquidity.

Once capital commitments are secured, the fund enters its investment phase, where the GP identifies and evaluates potential investment opportunities. The GP issues “capital calls” or “drawdowns” to LPs, requesting a portion of their committed capital to fund specific investments or cover operational expenses. LPs typically receive 10 to 20 days’ notice to provide the requested funds, allowing the fund to deploy capital efficiently.

After acquiring stakes in target companies, the private equity fund actively manages these portfolio companies. This involves implementing operational improvements, providing strategic guidance, and sometimes restructuring the business to enhance its value. The goal is to prepare the companies for a profitable exit. This active involvement distinguishes private equity from passive investment strategies.

Towards the end of the fund’s life, the focus shifts to exit strategies, where the fund sells its investments to realize returns for its partners. Common exit avenues include a trade sale (selling the company to another corporate entity) or an initial public offering (IPO), where the company lists its shares on a public stock exchange. Other strategies include a secondary sale to another private equity firm or a recapitalization (restructuring the company’s debt and equity).

Following successful exits, the fund proceeds with distributions, returning capital and profits to its Limited Partners and the General Partner. The typical life cycle of a private equity fund spans approximately 10 to 12 years, though it can extend up to 15 years depending on market conditions. This period is divided into distinct stages: fundraising, an investment period (often the first 3-5 years), and a harvest period where investments are exited and proceeds are distributed.

Fund Economics and Compensation

The financial arrangements within a private equity fund align the interests of the General Partner and Limited Partners. A primary component of GP compensation is the management fee, an annual charge paid by LPs to cover the fund’s operational expenses. This fee is typically calculated as a percentage of the committed capital during the investment period, and may shift to a percentage of invested capital or net asset value after the investment period.

Beyond the management fee, the General Partner earns compensation through carried interest, also known as “carry.” Carried interest represents the GP’s share of the fund’s profits, serving as a performance-based incentive. This share is typically 20% of the net profits generated by the fund’s investments, after LPs have received their initial investment back and a predetermined preferred return. This profit-sharing mechanism motivates the GP to maximize investment returns.

Before the General Partner can receive any carried interest, the fund must achieve a hurdle rate, also referred to as a preferred return. This is a minimum rate of return that Limited Partners must receive on their invested capital. Hurdle rates typically range from 7% to 8% annually, ensuring LPs achieve a baseline return before the GP participates in the profits. This mechanism provides protection for investors and further aligns the GP’s interests with the fund’s overall performance.

The allocation of capital and profits is governed by a distribution waterfall, a sequential mechanism dictating the order money flows back to LPs and the GP. The waterfall typically prioritizes the return of capital to LPs first, followed by the preferred return to LPs. After these tiers are satisfied, a “catch-up” provision may allow the GP to receive a larger share of subsequent distributions until they reach their agreed-upon percentage of the profits. Finally, any remaining profits are distributed according to the carried interest split, usually 80% to LPs and 20% to the GP.