A private equity fund is an investment entity formed by an investment adviser (often also referred to as a fund manager or sponsor), that raises capital from investors to make investments in private companies under a specified investment strategy. Typically, the investors commit to investing a certain amount of capital over time, in one or more capital calls made over the course of the private equity fund’s life cycle. The investors are passive and do not participate in the management of the fund or the selection of its investments. The fund manager is responsible for investing the assets pursuant to the fund’s investment strategy. Additionally, private equity funds are often “blind” (in that the investor does not know in advance what their money will be invested in) and anonymous (in that no investor knows the identities of the other investors).
Fund managers typically charge a management fee based on a set percentage of the value of the fund’s assets. In addition, as an incentive to drive high performance, the investment manager typically receives a share of the profits of the fund. Private equity investors seek and expect a higher rate of return on their investment than public investments since these funds are usually locked for a long period of time (8-12 years) and the managers of the fund are usually experts in the industry and locale of the investments.
There are a number of different types of private equity funds that use different investment strategies, such as:
- Venture capital funds, which invest in startup companies;
- Growth funds, which invest in later-stage, pre-IPO companies;
- Buyout funds, which purchase controlling interests in companies to flip those companies or taking them public; and
- Distressed funds, which buy the debt of distressed companies at a large discount.
Typical Private Equity Fund Organizational Structure
The structure of a private equity fund generally involves several key entities such as:
- The fund
- The fund’s general partner
- The fund’s limited partners (i.e., the investors)
- A management company
- Portfolio companies
The fund is usually a limited partnership (but sometimes a limited liability co`mpany). The fund manager (or one of its affiliates) acts as the general partner of the fund and the investors are the limited partners of the fund. The investors acquire their limited partner interests in the fund, which then makes the actual investments into portfolio companies for the investor’s benefit.
Often, the general partner will have an affiliate that serves as a separate management company to provide investment advisory services to the fund. This is the operating entity that employs the investment professionals, evaluates potential investment opportunities, and incurs the expenses associated with day-to-day operations and administration of the fund.
Private equity funds are usually closed-ended investment vehicles, which means the fund raises capital commitments during an initial fundraising period (typically 12 to 18 months), after which the fund may not accept additional investor commitments. In most cases, the commitment is not funded all at once, but in separate capital contributions called by the sponsor on an as-needed basis (known as “capital calls”) to make investments during the investment period and, if the fund’s limited partnership agreement permits, to pay fees and expenses.
Securities laws require that the investors of these funds meet various investment criteria in order to qualify. Depending on the structure of the fund, the state where the fund manager’s operations are located, and the amount of assets managed by the fund manager, investors may be required to be accredited investors, qualified clients, or qualified purchasers (or all three).
Investment Fund Entity Selection
As mentioned earlier, private equity funds are typically formed as limited partnerships (LPs) or limited liability companies (LLCs). The main reason these types of entities are use are:
- Unlike corporations, LPs and LLCs are not taxed as a separate business entity. Instead, profits and losses “pass through” to the members of the business. Corporations are subject to double taxation, where income is taxed to the corporation and then again to the owners when profits are distributed.
- LLCs and LPs are very flexible entities, especially those formed in Delaware. Just about any provision of the state LLC and LP statutes in Delaware can be overridden by the entity’s governing agreement, including those pertaining to fiduciary duties. This flexibility allows partners in an LP and members of an LLC to structure a wide variety of economic and governing arrangements. Corporations are largely governed by the corporation statutes and the rights of the parties can only be modified in specific ways authorized by the statute. Corporations also require the observance of more legal formalities.
- The investors in the fund, like the stockholders in a corporation, benefit from limited liability. The limited partners of an LP and the members of an LLC are not personally liable for the liabilities of the company. As result, an investor’s obligations and liabilities to contribute capital or make other payments to the fund are limited to the capital commitment and its share of the fund’s assets.
US-based private equity funds are typically formed under Delaware law, mainly for the following reasons:
- Delaware has a highly developed business entity case-law;
- As mentioned previously, Delaware’s LLC and LP statutes provide extensive freedom of contract, which gives fund managers and their counsel comfort that the terms of the entity’s governing agreement, including terms that limit fiduciary duties, will be enforced; and
- Delaware’s judicial system has judges with extensive knowledge and experience trying business cases.
Forming a private equity fund involves complex areas of law, so be sure to seek the advice of an attorney with relevant experience.
© 2018 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.