How does a Private Equity Firm Work?
Private Equity firms are accredited investors that have registered with the Security and Equities Commission. They are required to follow the rules and regulations of the SEC. PE Firms have General Partners (GPs) who usually spend 100% of their time and energy finding, executing and helping run companies.
PE firms raise funds which are the vehicles they use to invest in new companies. Firms buy and sell companies out of a given fund and returns are measured for each fund. PEs sometimes have multiple funds working at any given time. Funds are created by raising capital from Limited Partners or “LPs”. LPs can be any accredited investor and are often institutional investors such as pension funds, endowments or money management firms.
How do Private Equity firms make money?
Private equity firms also make money through two types of fees:
- Management Expenses
- Performance Fees.
The management fee is usually a small % of “committed capital” or the size of their fund. These fees are meant to cover operating expenses like their overhead, some of their employee costs and other G&A costs.
The performance fee, also called their carried interest, or just “carry” for short, is how PEs will make the majority of their money. The Carry is also a % of the fund but is more like 10-30% of the upside returns that they are able to drive. The performance fee is meant to align interest of GPs and LPs. PEs that are successful in buying, growing and selling companies drive a return for both the LPs and the GPs. Firms measure their return as an IRR or “Internal Rate of Return”. Each GP will measure their individual performance in terms of IRR as well and PEs see this as a yardstick of their success.
How do Private Equity Firms compete?
PEs will typically use a mix of strategic and opportunistic approach to investing. Strategic investing means that firms come up with a strategy or thesis on which they will invest. These strategies are sometimes called “themes”. Investing strategies will evolve with time and are often hotly debated. An example strategy would be investing only in companies that help with remote work given a global pandemic is spreading. While this strategy may seem smart with given conditions, other firms may have similar strategies that increase the demand (and thus price of investing) in these companies and soon the potential of getting a return greater than the market is rendered futile.
Opportunistic investing is when opportunities come across a firm’s radar given connections GPs or LPs have with privately held companies. Some firms try to adhere to strategic investing only, while others rely more on opportunistic investing.
Another way that firms compete is by focusing on either specific verticals of the market, or on specific stage of companies. Vertical focus is a fairly standard way to build strategy and many firms feel the more they invest in a given sector, the more knowledge and intuition they build on where and how to invest.
Picking a specific stage of company can also help firms compete. Many firms talk about both stage of company they will invest in and “check sizes” they will write. These two aspects also relate to how much risk they want to take with each investment. Some strategies have PEs, in particular, write bigger checks and take bigger stakes in companies. Other’s wish to write smaller checks and/or take a smaller % ownership of their portfolio investments. Many Partners and Directors think about their check sizes and % ownership in terms of how much time they have to help portfolio companies. This too feeds into strategy.