Whether you’re into finance or not, chances are you’ve heard about private equity before, if only to have a vague idea of what it involves. Today we’re looking at the ways private equity firms are actually making money.
First, let’s remind ourselves what a private equity firm is, as understanding what they do and how they function can help us understand how they make money. Private equity firms, or funds, are basically pools of money looking to invest in or buy companies. Their main goal is to sell and buy companies as part of their portfolio and are managed by general partners.
Private equity firms raise money from limited partners. These can include pension funds, university endowments or capital from other companies. Wealthy individuals can also choose to invest in private equity firms.
A significant portion of the money that private equity firms make come from management fees. Firms charge an annual management fee of around 2 to 3% of the money invested, which usually serves to pay salaries and cover operating costs before and between investments. These management fees are based on money invested and therefore not based on the performance of the fund – they ensure a steady revenue for the private equity firm as profits from the investment can be pretty lumpy over years.
Selling portfolio companies
As mentioned previously, private equity firms buy and sell companies. When selling a company for a higher price than they were bought for, the profits are then split between the limited partners (who invested the money) and the general partner (who managed the money). The general partner usually gets 20% of the profits made by the sale of the company, which is also called ‘carried interest’ or ‘carry’.
This carried interest is a huge part of the reason why private equity firms can make money, as general partners often only contribute 1 to 5% of the fund (10% at most) but still keep 20% of the profits. Those profits are then divvied up between senior partners and investments professionals at the firm. The whole process of distributing profits from the sale of a company is called the ‘distribution waterfall’.
Law firms and private equity firms
When it comes to private equity funds, law firms are often involved as the sums of money involved can reach several billions, so you need to make sure you have everything in order. As law firm Goodwin emphasises, in such competitive marketplace it’s vital to have the right insights, counsel and experience to cover the full lifecycle of investments.
Are private equity firms regulated?
Each country has their own way of regulating private equity funds, in the UK that’s the Financial Conduct Authority (FCA) and in the US that the Securities and Exchange Commission (SEC). Largely unregulated in the 40s, the industry is now much more under scrutiny and private equity firms in the US have to register with the SEC as ‘investment advisers’.
Private equity funds are part of a complex systems and it can be difficult for the non-initiates to understand the ins and outs of the industry. We hope this has shed some light on the way that private equity firms function and how they make money. If you’d like us to cover more topics about private equity funds, let us know!