Even though the history of private equity funds goes way back to the start of the last century, these funds didn’t really gain altitude until the 1970s.
And the 1970s was a time when the technology in the United States achieved a much-needed booster from venture capital. Many floundering and struggling companies managed to raise funds from private sources instead of going public in the market.
However, even if these funds promise great returns, average investors may not immediate access to these funds. Companies generally require a minimum investment of $200,000 or higher. That practically means private equity funds are focused toward institutional investors or those who have a lot of money at their disposal.
The Basics of Private Equity Funds
Private equity funds are closed-end funds that are treated as an alternative investment class. Since they are private, their capital is not listed on a public exchange.
And because of this characteristic, private equity funds let high net worth individuals and other institutions to invest directly in ownership of companies.
Funds may consider buying stakes in private companies or public firms with the intention of de-listing the public entity from stock exchanges to take them private.
For the most part, private equity funds have had much less regulations that the rest of the market. That’s because high net worth investors are considered to be better equipped to endure losses than average investors.
However, after the financial crisis, the government has treated private equity funds with more scrutiny than ever.
Fees and Expenses
The fee structure of a private equity fund is very similar to hedge funds, in that it charges both management and performance fee.
The management fee is about 2% of the capital committed to invest in the fund. For instance, if the fund has assets under management (AUM) of $1 billion, the management fee will be around $20 million.
This fee covers the fund’s operational and administrative fees like salaries, deal fees, and anything that is needed to run the fund.
And similar to any other fund, the management fee is charged even if the fund doesn’t generate a positive return.
On the flipside, the performance fee refers to a percentage of the profits generated by the fund that are passed on to the general partner.
These fees can be as high as 20% and they can be often dependent on the fund’s positive returns.
The idea behind the performance fee is that they help bring the interests of both investors and fund managers in line. If the fund manager is able to manage the fund successfully, he will be able to justify his performance fee.
Limited Partnership Agreement
When the fund raises money, institutional and individual investors agree to specific investment terms presented in a limited partnership deal.
Limited partners are liable up to the full amount of money they invest in the fund. On the other hand, general partners are fully liable to the market. That means if the fund loses everything, general partners are responsible for any debts or obligations that the fund owes.