New on FinoLib · Volume II: Capital Markets
New on FinoLib, my finance education website: I have published an article called Private Equity Fund Structure: LPs, GPs, Carry and Lifecycle, from Volume II: Capital Markets. Here is what the article explains, written as a short expert briefing; the full piece, with every worked example, is one click away.
2.8 Private Equity Fund Mechanics — LPs, GPs & Carry
The idea in plain words
A private equity fund is a partnership. The investors, called LPs, supply the money, and the manager, called the GP, invests it and earns management fees plus a share of profits called carried interest. Profits are shared in a set order called a waterfall: investors first get their money back, then a preferred return, then the manager catches up, and then profits split 80/20. So a fund that returns 1.80x gross pays its investors 1.64x.
Key points
■With a full catch-up the GP ends with 20% of all profit; the hurdle delays carry rather than reducing it.
■Carry switched on at 1.47x and the catch-up completed at 1.59x in the example.
■Deal-by-deal waterfalls pay earlier and need clawbacks; ILPA recommends clawbacks gross of tax.
A closer look
A private equity firm does not typically invest its own balance sheet money — it raises a fund from outside investors and manages that pooled capital on their behalf. The investors who supply the capital are Limited Partners (LPs) — pension funds, endowments, insurance companies, sovereign wealth funds, and wealthy individuals — who commit capital but have no role in day-to-day investment decisions. The PE firm itself acts as the General Partner (GP), making all investment decisions and managing the fund’s portfolio companies.
Decision rule
As an LP, read the fund terms from the bottom of the waterfall up. Prefer a whole-fund waterfall; if the GP insists on deal-by-deal, require an escrow of carry and a clawback calculated gross of tax, backed by guarantees from the individual partners. Check the fee base: fees on commitments for more than about five years, or with no step-down, deserve pushback.
The costliest mistake
Comparing a fund’s gross returns with net returns elsewhere. In the example, the gross 1.80x (12.5% a year) is 1.64x (10.4%) after carry, and $136 million of fees on a $1,000 million fund widens the gap further. An LP who chose this fund over a public index on the strength of its gross number may have bought a lower net return, less liquidity and a ten-year lock-up. Always compare net of fees and carry, against an index measured over the same dates.
Recap
LPs commit capital and GPs earn fees and carry through a waterfall of return of capital, preferred return, catch-up and an 80/20 split, which in the example turns a 1.80x gross fund into 1.64x for LPs. Deal-by-deal waterfalls need clawbacks, fees absorb about 13.6% of commitments, and US carry is a capital gain only after three years.
2.9 The PE Investment Lifecycle
The idea in plain words
A buyout fund has a life of about ten years. It spends roughly the first three to five years buying companies, then works to improve them, sells them and hands the cash back to investors. Because the money comes back late and in lumps, performance is read through several measures: DPI (cash already returned), RVPI (value still held), TVPI (the two together), IRR, and a comparison with public markets. Early IRR is the easiest to flatter, so look at the others too.
Key points
■The J-curve: fees come first, gains later, so early net value sits below paid-in capital.
■DPI counts cash returned; TVPI adds the GP’s own valuation of what is left.
■A one-year subscription line lifted one deal’s IRR from 15.8% to 19.3% while MOIC fell from 1.80x to 1.70x.
Decision rule
Judge a young fund by its strategy and its managers’ past funds, not by its IRR: before roughly Year 5, IRR mostly reflects fees, timing and the GP’s own valuations. From the middle of the fund’s life, weight DPI over TVPI, because only distributions are cash. Compare any fund with a public index over the same cash-flow dates (PME), and ask whether subscription-line borrowing has been used; if it has, ask for IRR calculated from the dates the fund invested, not the dates LPs paid.
The costliest mistake
Choosing managers by headline IRR. In the example above, a one-year subscription line lifts the reported IRR from 15.8% to 19.3% while the LP’s money multiple falls from 1.80x to 1.70x: the LP gets $6 million less on every $100 million deployed, the interest on the line, and the GP reports a better number. An LP ranking managers on IRR rewards the financing trick, not the investing.
What the full article covers
In the full article I take you through these sections:
■2.8 Private Equity Fund Mechanics — LPs, GPs & Carry
■2.9 The PE Investment Lifecycle
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Private Equity Fund Structure: LPs, GPs, Carry and Lifecycle, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
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