Navigating Private Equity: An Introduction for In-House Legal Counsel
Whether you are an in-house lawyer at a large, established company or at an early-stage startup, you should have a basic understanding of private equity. Private equity funds acquire and invest in companies of many varieties. Private equity funds often focus on specific investment sizes, industries, and geographic regions. They also have varying degrees of risk appetite and investment horizons.
Since private equity firms have become major financial market participants, your in-house legal department should understand the basics of private equity fund strategies, fund structures, how private equity firms go about sourcing investments, and the principal documents involved.
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Private Equity Fund Structure
The term “private equity fund” refers collectively to the group of entities that make up the fund structure. The fund structure is often driven by tax considerations.
Private equity funds pursue specific investment strategies in order to maximize returns to their investors and partners. Private equity funds are formed and managed by private equity firms, often called private equity sponsors.
The investors in private equity funds typically include a combination of pension funds, sovereign wealth funds, hedge funds, family offices, endowments, insurance companies, and high net worth individuals.
The private equity fund sponsors typically invest the capital provided by investors by acquiring a majority or significant minority ownership stake in a portfolio of privately-held companies. The goal is to make money for the private equity fund and its investors upon a successful exit from the investments. Exits or sales of portfolio companies can occur via an initial public offering (IPO) or a sale. The portfolio company sale can be made to a strategic buyer or to another private equity fund.
The fund structure involves a number of limited partners, who are the passive investors, and a small number of general partners. The limited partners or members do not have control in managing the fund or the fund’s investment strategy. These passive investors will be party to a Limited Partnership Agreement (LPA) and subscription agreements that set forth the terms that they must contribute capital to the fund.
The general partners manage the fund and its assets on a day-to-day basis. The general partner entity is usually structured as a limited liability company (LLC). The principals of the private equity firm will own LLC interests in the general partner entity.
Private equity funds often retain an investment adviser. The private equity fund will pay management fees to the investment adviser according to the terms set forth in an investment advisory agreement. Investment advisers are regulated by the strict conduct rules of the Securities and Exchange Commission (SEC) under the Investment Adviser Act of 1940.
Capital Contributions, Investments, and Distributions
From time to time, the general partner will “call” capital from its limited partners. When a capital call occurs, the passive investors must contribute the amount of capital they have committed as set forth in the LPA and subscription agreements they signed.
The general partners call capital from the limited partners on an as needed basis. The capital is used to facilitate portfolio company investments and to pay investment adviser fees and other expenses.
The distributions of a private equity fund upon a successful investment exit are determined according to a waterfall provision. The waterfall provision, which is detailed in the LPA, provides how the proceeds will be split between the investors and the general partners.
The typical waterfall involves the capital contributions made by investors being returned to them. This return of capital is often accompanied by a preferred minimum return or hurdle rate of 8%. Afterwards, the excess proceeds remaining will be split among the investors and the general partners. The typical split is 80% to the investors and 20% to the general partners. This 20% is referred to as “carried interest” or “promote.” Carried interest is subject to a lower rate of taxation than ordinary income. This results in major tax savings for the recipients of carried interest.
Private Equity Fund Strategies
The amount of assets under management (AUM) of the private equity fund shapes its ability to pursue different investment strategies. Other factors include its industry expertise, risk appetite, investment horizon, and geographic focus.
Private equity funds invest in portfolio companies ranging from early-stage companies to mature companies. For example, some private equity funds focus on growing capital investments. This involves acquiring minority stakes in companies that are more established that early-stage startups, but that still have significant expansion potential and are have not reached a mature stage.
Other private equity funds specialize in leveraged buyouts (LBOs), venture capital, mezzanine financing, and distressed buyout investments.
Fund Formation Documents
There are a number of standard documents involved in the formation of a private equity fund. They include:
- Private placement memorandum (PPM)
- Limited partnership agreement (LPA)
- Subscription agreements
- Investor questionnaires
- Side letters
- Investment management agreement
- Form D
The LPA is among the most important of these documents because it outlines the terms of fund investments and the manner of distributions of proceeds.