What Is the Structure of Private Equity Funds?

Private equity funds have a significantly different structure than the funds that the general public can access, i.e., mutual funds and exchange-traded funds (ETFs). One of the core differences is that there are no ‘fund units’ that you can buy and sell as and when needed. Instead, you need to be a partner in the private equity fund to invest in it.

The nature of asset ownership is much more direct in private equity funds.

Structure of Private Equity Funds

Private equity funds are typically structured as limited liability partnerships (LLPs) wherein the firms act as general partners (GPs) and investors act as limited partners (LPs). Most of the funding comes from LPs.

Unlike general partnerships, LLPs protect partners from personal liability. So, the personal assets of fund partners are not threatened if the fund fails to keep up with debt or other obligations.

The partnership structure helps partners avoid double taxation. Any proceeds generated by the fund are passed through without being taxed directly to the partners. As a result, only individual income tax is applicable for private equity fund investments in most cases.

Fee Structure of Private Equity Funds

In exchange for their services, GPs receive a fixed fee plus carried interest. Most private equity funds have a 2 and 20 fee structure wherein GPs receive 2% of the investments (fixed fee) annually and 20% of the profits after LPs receive their original investment amount plus a hurdle rate.

The fixed annual fee is typically calculated based on the total funds raised (formally known as capital committed) by the fund. However, once the investment period ends, it is calculated as per the net asset value.

Private Equity Fund Fee Structure Elements

Variable	Interpretation
Fixed annual fee	Minimum compensation for the time and resources invested by GPs
Carried interest	Incentivizes GPs to maximize fund returns, aligning the interests of GPs and LPs
Hurdle rate	Ensures a minimum return for the LPs

Example

Suppose investors contribute $100 million to a private equity fund with the following fee structure:

• Fixed annual fee – 2%
• Carried interest – 20%
• Hurdle rate – 8%

Assuming that the fund maintains a reserve for fixed annual fees and the deployed capital grows 30% annually, let’s visualize the fee payouts and the final payout for all parties. For the sake of simplicity, we will also assume that the fund stays active for 10 years, and then, all investments are fully exited.

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Capital raised/Starting net asset value	$100M	$127M	$163M	$209M	$270M	$348M	$450M	$582M	$754M	$977M
Funds set aside for fixed annual fees (B= Capital raised × 2%)	$2M	$2M	$2M	$2M	$2M	$2M	$2M	$2M	$2M	$2M
Deployed capital (C= A − B)	$98M	$125M	$161M	$207M	$268M	$346M	$448M	$580M	$752M	$975M
Investment growth (D= C × 30%)	$29M	$38M	$48M	$62M	$80M	$104M	$134M	$174M	$226M	$293M
Fund's net asset value at the end of the period (E= C + D)	$127M	$163M	$209M	$270M	$348M	$450M	$582M	$754M	$977M	$1.27B
Final payouts	Hurdle rate payout (a= Capital raised × (1 + 8%)10)									$215.89M
	Repayment of capital raised (b= Capital raised)									$100.00M
	Remaining profits (c= Final NAV − a − b)									$951.88M
	Carried interest payout (d= c × 20%)									$190.38M
	Remainder (Paid out to investors) (e= c − d)									$761.51M

Note: All values except final payouts and values exceeding $1 billion are rounded to the nearest integer.

In this scenario, the private equity firm earns $20 million in fixed annual fees and $190.38 million in carried interest. In contrast, investors received $1.08 billion. The fund delivered annual returns of 26.83%.

What Is the Investment Timeline for Private Equity Funds?

A private equity fund’s lifecycle can be divided into the following four phases:

Capital Call

The private equity firm begins by forming a detailed investment strategy that also outlines initial investment targets. Once the firm is confident in its hypothesis, it will start compiling a prospectus . The prospectus is shared with potential investors, and if the minimum amount of funds is raised, the firm will launch the fund and begin investing.

Investment

To ensure that capital does not remain underutilized, firms will try to deploy most of the capital within 2 years. These investments are then held for another 8-10 years. Depending on the fund type and investor preferences, any early exits may be reinvested or distributed.

Extension

In periods of low liquidity, funds may be forced to extend their lifecycle. This would mean holding the investments beyond the high growth period, which reduces the time-adjusted return.

For instance, if a company grows at 30% CAGR for 3 years and then at 10% CAGR for the next 2 years, the CAGR for the entire 5-year period would be 21.60%. If the company didn’t grow in the final 2 years, the CAGR would drop to 17.05%.

But that’s not the worst-case scenario. With high-risk investments like startups, there’s also a chance of complete loss if the company shuts shop.

Exits

Once the fund secures exits with no viable reinvestment plans, it will begin distributions. This phase continues until the investment inventory is exhausted. A firm’s exit efficiency can be measured by studying the trends in total value to paid-in capital (TVPI), residual value to paid-in capital (RVPI), and distribution to paid-in capital (DPI) in exit phases.

Eqvista – Accurate Valuations for Confident Investor Communications!

Private equity funds operate through a carefully structured partnership model that balances risk, returns, and incentives between general and limited partners. Understanding these structural elements is crucial for evaluating fund performance.

If your investors are new to private equity and need reassurance regarding fund performance, consider relying on Eqvista. Our valuation analysts are seasoned veterans in calculating fund NAVs and startup valuations as per 409A guidelines and industry norms.

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