How private equity and venture capital funds work
Who gives the money, how funds are set up, fees and carried interest, the deal cycle, and why private equity hires consultants.
Industry brief, with a one-minute summary: Private equity and venture capitalKey takeaways
- A private equity (PE) firm raises a fund from investors, buys companies, tries to make them more valuable over a few years, and then sells them.
- Is the market attractive (size, growth, profitability)? Is the company winning in it (share, customer view, advantages)?
- The PE firm is the general partner (GP): it chooses and manages the investments.
Key idea
A private equity (PE) firm raises a fund from investors, buys companies, tries to make them more valuable over a few years, and then sells them. It earns a yearly management fee plus a share of the profit, called carried interest.
The PE firm is the general partner (GP): it chooses and manages the investments. The investors in the fund are limited partners (LPs): pension funds, insurers, sovereign wealth funds, university endowments, family offices, and funds of funds. LPs promise (commit) money when the fund is raised, and the GP calls it when it finds deals. A typical fund lives about 10 years: roughly 5 years to invest and 5 years to grow and sell the companies, often with extensions.
| Type | What it buys | How it makes returns |
|---|---|---|
| Buyout | Control of mature, profitable companies, often using debt (a leveraged buyout, LBO) | Earnings growth, debt paydown, and sometimes a higher sale multiple |
| Growth equity | Minority stakes in fast-growing companies that already make money or are close to it | Revenue growth |
| Venture capital (VC) | Minority stakes in young startups, from seed to later rounds | A few very large winners pay for many failures |
| Private credit | Loans to companies, often those owned by PE funds | Interest and fees |
| Infrastructure and real estate | Toll roads, data centers, towers, ports, buildings | Steady cash income plus value growth |
So-what
Ask which type of fund the client is. A buyout fund cares about cash flow and debt; a VC fund cares about how big a startup could become.
Fees and carried interest
The classic model is often called "2 and 20". The GP charges a management fee of about 1.5 to 2 percent a year, usually on committed capital during the investment period and on invested capital after that. It pays the team and office costs. The GP also earns carried interest (carry), commonly 20 percent of the fund's profits, but usually only after LPs get their money back plus a minimum return called the hurdle rate, often 8 percent a year. The order in which money is paid out is called the distribution waterfall. Terms vary by fund and have come under pressure from large LPs.
- Private equity deal cycle
- Fundraising from LPs
- Sourcing dealsFinding companies, often through bankers and sector themes.
- Key: Due diligenceCommercial (market and competition), financial, legal, tax, IT, and environmental checks.
- Deal structuring and financingPrice, debt, and terms.
- Key: Ownership and value creationGrowth plans, pricing, cost programmes, add-on acquisitions (buy-and-build), better management.
- ExitSale to a company (trade sale), sale to another PE fund (secondary buyout), stock market listing (IPO), or a continuation fund run by the same GP.
Consultants are hired at several steps, most often due diligence and value creation.
Why private equity hires consultants
Commercial due diligence (CDD) answers one question before a PE firm bids: will this company's business plan hold up? In two to six weeks, consultants size the market and its growth, test the company's competitive position, interview customers and experts, and check whether the management plan is realistic. Sellers also hire consultants for vendor due diligence, a report they give to buyers. After a deal, PE firms hire consultants to build a 100-day plan, cut costs, fix pricing, and prepare for the exit. Because PE firms do many deals a year and need answers fast, they are a large and steady source of consulting work.
Is the market attractive (size, growth, profitability)? Is the company winning in it (share, customer view, advantages)? Is the business plan achievable? What are the risks and the upside? A CDD case in an interview usually follows these four questions in this order.
In a private equity fund, who are the limited partners?
Sources for this lesson (1)
- Recognized public explanations of case-interview concepts and frameworks
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