How Do Private Equity Funds Work
By Linda Zuo on The Capital
Nowadays, people can easily buy or sell stocks or bonds from listed companies as part of their personal investment portfolio. To be listed on public markets, companies have to meet strict requirements and disclose a substantial amount of information. However, not every company can fulfill these requirements or would like to go public. These businesses rely on private markets for their corporate finance, attracting sophisticated investors like institutions or high-net-worth individuals, as opposed to straightforward public investors like you and me. Just like public markets, in private markets, people can invest in equity (stocks), credit(bonds) or assets (real estate, infrastructure, and equipment).
The life cycle of a private equity fund begins with a ‘money pool’, known as a fund. Fund managers approach potential investors who then agree to make a capital commitment to the fund for future investment. At this stage, investors’ money is not sent to the fund’s account. This does not happen until the fund manager calls the capital when it invests in a portfolio company. In years 6–10, fund managers begin to exit portfolio companies by selling or transferring their ownership and sending capital (cash or stock) back to investors. In the context of private equity, fund managers are called general partners, or GPs, and they are responsible for daily fund operations and management. Investors in the fund are called limited partners, or LPs, and they contribute the capital and delegate management rights to GPs.
For private market deals, there are no pre-defined rules, therefore GPs need to spend more time structuring and negotiating deals. Once the deal is approved, GPs will step into the companies they invest in, known as portfolio companies, and look for opportunities to add value to them, increasing the value of their investment. GPs normally have extensive knowledge in their investment area. Their expertise can be helpful in improving the portfolio companies’ operational efficiency and optimizing capital structures through financial engineering. Sometimes, they may even become board members and steer the strategic direction of the company.
Depending on the stages of portfolio companies, the private equity fund can be classified into four categories from the emergence of a company to its disappearance: venture capital, growth capital, buyout fund, and special situation fund.
To decide which fund to invest in, LPs will carefully assess a fund manager’s track record by analyzing the fund’s performance and investment return. Regardless of the return, GPs charge LPs a fixed amount of money (known as a management fee) annually to perform daily operations; for example, if the value of the investment exceeds the pre-defined minimum expected return (a figure known as the hurdle), staff are paid an additional reward known as carried interest on top of their salaries. This fee structure aligns the interests of GPs and LPs, so both partners are motivated to improve the fund’s performance. Deal sourcing and value generation are the other two metrics that investors will consider when choosing a fund. A good manager should have access to bilateral, ‘off-market’ deals and have in-house corporate experts to manage the acquired businesses.
Within the private equity universe, in addition to LPs and GPs who are responsible for investing capital, fund administrators and fund custodians also play an important role in the process. Fund administrators prepare financial statements, pay fund expenses, monitor regulatory compliance and perform other administrative functions. Fund custodians are financial institutions that hold and safeguard the assets owned by the fund. To avoid any conflict of interest, these two roles are independent from GPs and LPs.
