Structure of PE Funds and the Economics of GP/LP

Private Equity: The architecture of the Private Equity (PE) industry—a class of alternative investments that involves acquiring stakes in private companies or buying out public companies followed by delisting. The PE industry manages assets exceeding $8 trillion and is a key element in institutional investors' portfolios.

Structure of a PE Fund

A typical PE fund is organized as a Limited Partnership (LP) with two categories of participants:

Lifecycle of a PE Fund

The standard lifetime of a fund is 10 years, with possible extension for 2-3 years:

GP Economics: Sources of Income

The General Partner earns compensation through several mechanisms:

1. Management Fee

Management fee is usually 2% per annum on committed capital during the investment period and on invested capital during the harvesting period:

• Fund $1 billion → Management fee $20 million/year
• Covers GP's operational expenses: salaries, rent, travel, due diligence
• Large LPs may negotiate reduction to 1.5% or fee breaks

2. Carried Interest

Carried interest is GP’s share in the fund's profit, usually 20%:

• Paid only after LPs have received their investments + hurdle rate
• Hurdle rate (preferred return) is typically 8% per annum
• After reaching the hurdle, catch-up applies: GP receives 100% of distributions until leveling to 20/80

Distribution Waterfall Formula:

European Waterfall (more conservative):

• Return of all invested capital to LPs
• Preferred return of 8% on invested capital
• GP catch-up to 20%
• Distribution 80/20 (LPs/GP)

American Waterfall (deal-by-deal):

• Return of invested capital per specific deal
• Preferred return per deal
• Carry is distributed after each successful exit

3. GP Commitment

GP invests its own funds in the fund—typically 1-5% of the fund size:

• Demonstrates alignment of interests with LPs
• Fund $1 billion → GP commitment $10-50 million
• Large institutional LPs require a minimum of 2-3%

Capital Calls and Distributions

LPs do not contribute their entire commitment at once—capital is requested as needed:

Capital Calls (Drawdowns)

• GP sends a notice 10-15 business days in advance
• LP must contribute the requested amount
• Failure results in default and loss of stake
• Typical profile: 25% in year 1, 25% in year 2, 20% in year 3, remainder in years 4-5

Distributions

• Return of capital and profits after successful exits
• Forms: cash, in-kind (shares of portfolio companies after IPO)
• Recallable distributions: GP may request return for new investments

J-Curve: Visualization of Cash Flows

J-Curve—a characteristic pattern of cumulative cash flows for a PE fund:

Graphical depiction of the J-Curve:

Cumulative Cash Flow
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|----------------**-------------------------> Time
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|                  *
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Historical Returns by Vintage Years

Vintage year—the year of the fund’s first closing. Returns vary significantly:

Key Terms

Types of LP Investors

Recommendations for LP Investor

• Plan liquidity: Capital calls are unpredictable, maintain reserve
• Vintage diversification: Invest annually to smooth the J-curve
• Manager selection: The difference between top quartile and median is huge (500+ bps)
• Read the LPA: Limited Partnership Agreement defines your rights
• Negotiation power: Large tickets provide leverage for better terms