Basic, lesson 1 of 3
How a PE fund works
A PE firm raises a fund from outside investors, buys companies with it over a few years, sells them over a few more, and takes a fee plus a share of the profits.
8 min, 3 checks
1LPs and the GP
The money comes from limited partners, or LPs: pension funds, university endowments, sovereign wealth funds, insurers, family offices. They commit capital to a fund but do not hand it all over on day one. The PE firm, the general partner or GP, calls the money as it finds deals, a process called a capital call.
The GP makes every investment decision. LPs are passive: they picked the manager, and now they wait. The GP also puts in a small slice of its own money, often a low single digit percent of the fund, so it shares in losses.
Check 1
Who decides which companies a buyout fund buys?
2The life of a fund
| Years | Phase | What happens |
|---|---|---|
| 0 to 1 | Fundraising | The GP markets the fund and LPs commit |
| 1 to 5 | Investment period | Capital is called and deals are made |
| 4 to 10 | Harvest | Companies are improved and sold, cash goes back to LPs |
| 10 and after | Extensions | Stragglers are sold, often with LP approval to extend |
Firms raise a new fund every few years, usually while the last one is still investing. The pitch for the next fund rests on how the last ones did, which is why GPs care so much about returning cash on time.
3Two and twenty, roughly
The GP earns in two ways. The management fee, historically around 2% a year, pays salaries and costs. During the investment period it is usually charged on committed capital; afterwards it often steps down or switches to invested capital. The bigger prize is carried interest, or carry: commonly 20% of the fund's profits.
Carry usually only kicks in after LPs get their money back plus a preferred return, often 8% a year. Many funds then have a catch-up, where the GP takes a larger share until it has 20% of all profits. The exact terms are negotiated fund by fund.
Check 2
A $500m fund charges a 2% management fee on commitments. How much does the GP collect each year in fees?
Worked example
Gross versus net returns
- 1LPs put $1,000m into a fund over its life, fees included, and get $1,800m back.
- 2Profit is $800m. Assume the fund cleared its 8% hurdle and the catch-up, so the GP earns 20% of all profit: $160m.
- 3LPs receive $1,800m minus $160m, which is $1,640m.
Before carry the fund returned 1.8x; net to LPs it is 1.64x. LPs judge managers on the net number.
Check 3
A fund returns $2,500m on $1,000m of capital. With 20% carry on all profits, how much carry does the GP earn?
Terms in this lesson: Private equity, Limited partner, General partner, Capital call, Leveraged buyout, Management fee, Carried interest, Hurdle rate.
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