The Private Equity landscape has witnessed exponential growth and transformation in recent years, leading to significant changes in how Limited Partners (LPs) and General Partners (GPs) collaborate. The synergy between these essential stakeholders forms the cornerstone of thriving investment ventures and determines the overall performance of a Private Equity fund.
In 2022 alone, Private Equity buyouts reached $654 billion USD, showcasing the potential of this investment arena. Moreover, projections indicate a robust growth of over 10% CAGR from 2023 to 2028, emphasizing the importance of effective partnerships.
In this article, we will explore how this remarkable growth has influenced the evolving bond between LPs and GPs. We will also share valuable insights on how to best manage and strengthen the partnership between these key players.
How does a Private Equity firm work?
Before exploring the relationship between Limited Partners and General Partners, let's first understand how a Private Equity firm operates and the roles played by LPs and GPs.
Private Equity firms are specialized investors that pool funds from various sources. These sources include institutional investors, high-net-worth individuals, multifamily funds, and financial institutions. They focus on investing in privately held companies or acquiring public companies to take them private. These firms use their finance, strategy, and operations expertise to create value in their investments, ultimately generating returns for LP investors.
The nature of Private Equity firms allows for relatively faster decision-making. Often acting as both corporate management and the corporate board of directors, Private Equity partners can remove a layer of management. This dual role ensures active engagement in portfolio companies' performance while upholding a clear strategic vision for growth and value of investments.
The inner workings of a Private Equity firm are broken down into four key stages: fundraising, deal sourcing, value creation, and exit.
The initial stage of a Private Equity firm's operation involves raising capital from Limited Partners. Some examples of LPs are pension funds, endowments, family offices, sovereign funds, multifamily funds, and wealthy individuals. This capital is pooled together to form a Private Equity fund, which typically has a lifespan of 7 to 10 years. The firm's General Partners are responsible for managing the fund, making investment decisions, and overseeing the fund's overall performance.
- Deal sourcing
After setting up the fund, the Private Equity firm's goal is to find and invest in promising opportunities. This first step in this process, known as deal sourcing or deal origination, involves conducting initial research, and reaching out to companies that fit the fund’s thesis, or working with intermediaries like investment bankers to source potential deals. The GP conducts an initial screening to filter out deals that do not align with the fund's strategy or meet its risk-return profile.
- Due diligence
For the shortlisted deals, the GP performs extensive due diligence, which may include financial, legal, and operational assessments. They scrutinize the target company's financial statements, growth prospects, management team, and industry dynamics to determine the investment's viability. The LPs receive updates on the due diligence process and may provide input, but the GP carries the primary responsibility for this stage.
- Deal execution
Once the GP decides to proceed with an investment, they negotiate the deal terms, structure the transaction, and arrange financing. This may involve working with banks, other financial institutions, or even other Private Equity firms. The GP usually consults with LPs on significant deal terms, but they are primarily responsible for executing the transaction.
- Value creation
After investing in a company, the Private Equity firm works on making it more efficient, profitable, and valuable. These value-creation initiatives may include streamlining operations, optimizing supply chains, improving management teams, and pursuing strategic acquisitions or partnerships. Throughout this process, GPs work closely with the portfolio company's management, providing guidance and resources to help them achieve sustainable growth and performance improvements.
The final stage of a Private Equity firm's operation comes when they exit the investment. This usually occurs between three and seven years after the initial acquisition. The exit strategy is crucial, as it is the point at which the firm receives the gains generated from its value-creation efforts. Common exit strategies include taking the company public through an initial public offering (IPO), selling the company to another Private Equity firm or strategic buyer, or recapitalizing the business.
Learn more: Check out this comprehensive masterclass on fundraising and investor relations.
Who are Limited Partners (LPs)?
Limited Partners in Private Equity provide the funds raised by General Partners. To understand the role of the LP, we'll look at who qualifies as an LP, how they invest in Private Equity funds, and their responsibilities.
Who qualifies as an LP?
Limited Partners can be accredited or non-accredited investors. Accredited investors meet income and net worth requirements set by regulators like the Securities and Exchange Commission (SEC), allowing them to handle private equity risks. Non-accredited investors don't meet these rules and thus face investment limits.
Traditional LPs include institutions like labor unions, insurance companies, universities, and wealthy families. Today, many high-net-worth individuals can invest in Private Equity funds as accredited investors.
Process of investing in Private Equity funds
LPs invest in Private Equity funds through a commitment to provide a certain amount of capital over the fund's lifetime. Managed by General Partners, the firm asks for capital from LPs as investment opportunities come up. LPs usually have limited control over investment decisions, with GPs responsible for finding, buying, and managing portfolio companies.
Roles of an LP and consequences of default
As the name suggests, Limited Partners have limited liability (limited partnership), which means their potential losses are restricted to their initial capital commitment. They are passive investors who rely on the expertise of GPs to manage their investments. If an LP defaults on their capital commitment, they may face legal repercussions, loss of future investment opportunities, and potential damage to their reputation.
Return on investment for Limited Partners
LPs' returns depend on the performance of the fund's portfolio companies and the fund's success. Private Equity investments generally have a longer investment horizon and higher risk compared to traditional investments. However, they also have the potential to yield significantly higher returns.
LPs usually get returns through capital gains, dividends, or interest from the fund's investments. The returns are distributed based on the fund's legal and financial structure as well as the provisions outlined in the limited partnership agreement.
Who are General Partners (GPs)?
General Partners are the driving force behind Private Equity firms, responsible for managing the investment funds and making critical decisions about acquiring and managing portfolio companies. GPs are typically experienced professionals with extensive finance, strategy, and operations knowledge. They find, assess, and execute investment opportunities, creating value for the firm and investors.
Roles of a GP
GPs hold a wide range of responsibilities within Private Equity firms. Some of their primary duties include:
- Fundraising: GPs are responsible for raising capital from Limited Partners for the Private Equity fund. They present the firm's investment strategy and track record to potential investors and secure commitments from them.
- Deal generation: GPs network to find, cultivate, and utilize relationships with potential deal partners or deal sources like Venture Capitalists and Investment Banking executives. They also expand and strengthen relationships within their fund's sectors by attending and speaking at events and conferences or publishing thought leadership pieces on their blog or other social channels.
- Deal evaluation: GPs identify potential investment targets, conduct due diligence, and assess each investment opportunity's viability and potential returns.
- Negotiating and executing transactions: Once an investment opportunity is identified, GPs negotiate the terms of the deal, structure the transaction, and oversee its execution.
- Managing portfolio companies: GPs actively manage the acquired companies by implementing strategic initiatives, improving operational efficiency, and monitoring financial performance to maximize value.
- Exit planning and execution: GPs choose the best exit strategy, like an IPO, merger, or sale, and execute the exit to achieve returns for the fund.
Return on investment of GP
General Partners typically earn returns via management fees and carried interest. Management fees, which compensate for fund management activities, usually account for 1-2% of the fund's capital or net asset value.
Suppose a Private Equity firm raises a $100 million fund. The management fee, which compensates for fund management activities, usually accounts for 1-2% of the fund's capital or net asset value. In this case, if the management fee is 2%, the GP would receive $2 million per year for managing the fund.
In addition to management fees, GPs also earn carried interest. Carried interest represents around 20% of the fund's profits and is allocated to GPs after investments achieve a specific return threshold for Limited Partners. For instance, if the Private Equity firm invests the $100 million fund and eventually generates a total return of $300 million (a $200 million profit), the carried interest would be 20% of this profit, or $40 million.
This carried interest is commonly distributed among the members of the Private Equity firm, with the allocation often based on their respective positions within the organization. For example, senior partners might receive a larger share of the carried interest, while junior partners and associates receive a smaller portion, reflecting their level of responsibility and involvement in the firm's investment decisions and management activities.
What is the hurdle rate?
The hurdle rate represents the minimum acceptable rate of return (MARR) an investor expects to achieve from an investment. In Private Equity, the hurdle rate determines the threshold at which GPs can start receiving carried interest from the profits generated by the fund.
LPs and GPs negotiate the hurdle rate for a fund, typically setting it around 8% per annum. This rate ensures both parties' interests align. And the GPs receive a share of the profits only after LPs achieve a satisfactory return on their investments.
Example of the hurdle rate:
Consider a Private Equity fund with a hurdle rate of 8% and a carried interest structure of 20% for the GPs. In this scenario, the GPs will only start earning carried interest once the fund generates returns exceeding the 8% hurdle rate.
Let's assume the fund has an initial investment of $100 million and generates a return of $130 million after a specific period. The profit of $30 million must first be distributed to the LPs to cover the 8% hurdle rate. In this case, the LPs would receive $8 million (8% of $100 million). The remaining profit of $22 million would then be split between the LPs and GPs according to the carried interest structure. The GPs would receive 20% of the $22 million, which amounts to $4.4 million, while the LPs would receive the remaining 80%, or $17.6 million.
By establishing a hurdle rate, investors can meet their minimum return expectations before the fund managers receive their share of the profits. This alignment of interests helps balance risk and reward for both LPs and GPs in Private Equity investments.
What are escrow and claw-back?
Escrow and claw-back are mechanisms that guarantee limited partners receive their fair share of returns from a fund.
In escrow, a neutral third party holds and manages payment of funds, ensuring all parties involved fulfill the agreement's terms. In Private Equity, an escrow account can store a part of the GP's carried interest until the fund realizes its investments and distributes returns to LPs.
The main purpose of escrow in Private Equity is to reduce the risk of GPs receiving carried interest too early or above the agreed amount. This arrangement reassures LPs that their returns are secure and that GPs will only get their share once specific conditions are met.
Example of Escrow:
Imagine a Private Equity fund with a $100 million total investment, producing a $150 million return. The GP is entitled to 20% carried interest after reaching the agreed hurdle rate. Instead of immediately distributing the entire carried interest to the GP, a part of it goes into an escrow account. The escrow-held funds will only be released to the GP once the fund realizes its investments and the LPs receive their returns.
A claw-back provision is a contractual agreement allowing LPs to reclaim excess carried interest paid to the GP if the investment profits don't reach the predetermined threshold. This provision ensures GPs don't receive more than their fair share of the fund's profits.
Example of Claw-Back:
Suppose a Private Equity fund has many investments, and one investment generates a significant return early in the fund's life. This will lead to the GP receiving carried interest. However, subsequent investments underperform, causing the fund's overall return to drop below the agreed threshold. In this case, the claw-back provision allows LPs to recover the excess carried interest paid to the GP earlier in the fund's life. And thus ensuring fair distribution of returns between LPs and GPs.
How to improve relationship management for LPs and GPs
Private Equity partnerships thrive on trust, communication, and shared goals between LPs and GPs. Here are some strategies to enhance relationship management between these key stakeholders:
1. Establish clear expectations
From the outset, both LPs and GPs should set clear expectations about the investment strategy, risk tolerance, and desired returns. This mutual understanding will help to align interests and reduce potential conflicts. Research has shown that 35% of LPs do not seek improved alignment with GPs in terms of factors such as performance fees, highlighting the need for better negotiation.
2. Maintain open communication
Effective communication is essential for building trust and fostering transparency between LPs and GPs. Sharing updates on the fund's performance, investment decisions, and market trends can help keep LPs informed and engaged. Some ways to achieve this are periodic reports, conference calls, and in-person meetings.
When conflicts arise, addressing them together prevents them from escalating and negatively impacting the relationship between LPs and GPs. Maintaining a healthy partnership requires an open dialogue and a willingness to find mutually beneficial solutions.
3. Adopt a collaborative approach
Encouraging collaboration between LPs and GPs can lead to better decision-making and better partnership. By involving LPs in the decision-making process and seeking their input on critical issues, GPs can show that they value their investors' expertise and insights.
4. Enhance reporting and analytics
Providing LPs with comprehensive and timely information about the fund's performance is vital for maintaining their confidence and trust. Using technology to improve reporting and analytics offers LPs greater visibility into the fund's activities, keeps them informed about progress, and increases the likelihood they will consider investing in the next fund.
Unfortunately, many Private Equity firms currently use simplistic, antiquated spreadsheets for position monitoring, which can lead to breakdowns in communication. Investing in a centralized, easy-to-use database can help improve confidence, sentiment, and relationships.
Foster better collaboration with limited partners using Affinity
The relationship between LPs and GPs is a critical aspect of the Private Equity ecosystem. Strengthening this partnership is essential for greater collaboration and successful investments. As the Private Equity landscape evolves, transparency and mutual trust become even more important for both LPs and GPs.
Using tools like Affinity, which has robust data analytics and an intelligent CRM platform, is crucial for improving collaboration and building better relationships between LPs and GPs. Affinity helps firms use data-driven insights to streamline communication and align LPs and GPs.
Ready to revolutionize your LP and GP relationships? Discover how Affinity can transform your Private Equity firm and empower you to achieve greater success. Learn more about Affinity and get started today.