How Private Equity Funds REALLY Work: Full GP/LP Structure Explained

Today, I'm going to break down exactly how private equity funds are structured, how the GPLP model works, how carry flows, how management fees are earned, and how fund managers actually get paid. If you ever heard of the term private equity and wondered how these massive firms structure their funds, how they buy companies, or how money moves behind the scenes, this video is going to make it all crystal clear. Think of this as a guided walkthrough. We're going to use a simple $50 million private equity fund as our example to make all the pieces click together. So what exactly is a private equity fund. So down to the iPad here. A private equity fund is essentially a pool of capital raised from investors over here that put money into this pool for the purpose of buying private companies or equity in privately held businesses. And typically they're improving these businesses, doing good things, growing the businesses, and hoping to sell for a big profit that they can return back to the pool of money and split those returns between their investors and themselves, the fund managers over here. This is very similar to how hedge funds run, venture capital, real estate fund, private credit funds. They're all a pool of money that invests into a certain thing that then when that thing returns money, they just split the returns between the investors and the fund managers. Now, the closest sister to private equity would be venture capital. Venture capital also seeks to invest into businesses and grow them and do good things with them. Unlike venture capital, which usually invests into early-stage startups. Private equity invests into businesses that have more structure behind them. They already have things like cash flow, established operations, real customers, and a proven business model, where venture capital, on the other hand, is investing usually into an idea and a very early-stage team. And funny enough, most venture capital firms eventually hope to sell their portfolio funds to larger private equity firms or eventually sell them onto the public markets as an IPO, where maybe hedge funds will come and buy those things. But again, in the world of funds, these are all essentially just a pool of money looking to drive returns for investors. But again, today's topic is on private equity, and private equity is in the business of acquiring established companies, improving them, and selling them to generate profit. Now, most private equity funds are built on this exact same basic framework, the GPLP structure. Instead of calling it a pool of capital, they call it a limited partnership, as you can see on my screen here. And you see little pool here that stands for our pool of capital. Instead of having investors, they have limited partners here, LPs, that invest into the limited partnership, the pool of capital. Instead of having just fund managers, these fund managers are called the general partner and the management company over here. These help make the investment decisions of what's happening in the limited partnership that ultimately goes and buys these companies to generate a profit and produce a return back to the limited partnership that then is split between the limited partners and the general To break this down even simpler, LPs, limited partners, contribute the capital, and the GP, general partner, controls the fund and decides what investments to make. This is how the largest funds in the world run. And all of this is governed by 2 documents, your LPA and PPM, that I lovingly call the Bible because it is the bylaws and covenants and laws of your fund. This structure has been used for decades. Because it cleanly separates investor capital from fund manager control and allows the manager to operate efficiently without interference. All right, let's come back to our $50 million private equity fund example. So here's the structure: investors commit $50 million to the limited partnership, and they sign an LPA and a PPM that defines how they're going to get paid back. And for this example, we're going to use a pretty common structure, which is a 2% management fee and an 80/20 split on profits. We'll come back to this in a minute. You as the fund manager come over and set up your general partner, your GP, and that will be where your investment committee is to make and help decision-making. And then also you set up your management company. Your management co is where your salary, staff, overhead, and operations all live right here. And this is what collects the 2% management fee per year. The 20% carry goes to the general partner here. Typically, though, these are owned by the same individual. This is you and your team will also be on the GP and the management company. So this is how money flows in the fund. LPs commit the capital to limited partnership. The limited partnership, by direction of the general partner and management company, goes and makes investments. In this case, it's buying businesses. Sometimes they'll set up like an SPV blocker entity just to do that, but they go and buy these businesses. They invest, they hire staff, and they buy a bunch of these great businesses. When the investments make money, the money flows back to the limited partnership and then is split between the LPs and the general partner. Now let's talk about how that split works, which is usually called a waterfall distribution, how the GP, the management company, and the limited partners all get paid. Now, as a note, with a $50 million private equity fund, you probably don't need all $50 million day one. You're going to call this capital down in tranches of maybe $5 or $10 million as you need it to buy these investments. Furthermore, these funds can use leverage. Oftentimes, if you raised $50 million, you could probably borrow from a bank an additional $75 million of debt financing for a total purchasing power of $125 million to then go and make these investments. Now let's talk about how the GP and management company get paid in 2 parts. Part one is the management fee. Now, private equity funds usually charge a management fee of around 2% per year, and that's usually taken at 0.5% per quarter. Now, some funds do an acquisition fee or disposition fee, but for today, we're just going to talk about a 2% management fee. So on a $50 million fund, 2% of $50 million would be $1 million per year pending the whole fund is called down. Now, it's a good note. Most funds, if you only call half this capital, use $25 million of the $50, you're usually only taking management fees on the money that you are using. But for this example, let's assume that you've just called down all $50 million. And so you're making $1 million a year in management fees that are paid over to your management co here to help keep staff, lights on, office space, etc., all in the management company. Now, part 2 of getting paid comes to the G GP, this is what's called carried interest or carry. Carry or carried interest is the profit share the GP earns for growing the investor's money. This can be structured in a lot of different ways, but the standard structure is 80% to the limited partners and 20% to the general partner. Something to remember though, this is not a salary. This is not guaranteed. This is a reward for making profitable deals as the GP. This is your carrot. This is why people go to business school and work on Wall Street and try to make all these things so that one day they can be on the GP and earn some carried interest. So I'm going to jump over to my Excel spreadsheet here and show you some math to break down how this would work in this example of a $50 million fund. So you can see here we have private equity breakdown. Let's say we've raised $50 million of equity and we borrowed $75 million of debt, which gives us a total purchasing power of $125 million. Now, we believe we're going to double the size of this portfolio. We're going to do a 2x over 3 years, which is pretty good. So over the next 3 years, we believe we can double this company or group of companies from $125 to $250 million. So let's go down further of how this math would break out. Okay. Let's say we're borrowing that debt of $75 million at a 6.5% interest rate per year. So our debt service per year would be $4.875 million. And if you total that up over 3 years, that's $14.6 million. Now, I know I'm going fast here. You can go back and rewatch this, but we'll just go fast for everybody here. So let's say our plan works and we crushed it perfectly, which, by the way, never happens. But for the Excel model's sake, we crushed it. All right. In 3 years, we doubled our money. We took our portfolio from $125 to $250 million. You can see my math there. Now let's pay everything back and see how the splits work. So total debt payback. You can see my math here. Over 3 years, I'm paying back my $14 million plus my $75 million for a total payback of $89 million. During that period, we charged $3 million of management fees, assuming all $50 million was called and we charged 2% per year. That would be $50 million. Okay. For a subtotal of $157 million. You can see here, I took $250 minus $89 minus $3 brings us to $157. All right. That's how much we made as profit, which is pretty darn good. Well done, you guys. Well done. Again, it never works like this, as perfect as this, but it's working perfect right now on the Excel spreadsheet. All right. So first thing we got to do is equity payback to investors. Most private equity funds make you pay back all equity first to investors. Great. So investors gave us $50 million. Let's pay that back first. So $50 million is paid back first, leaving us with $107 million of gains. Not too bad. Now we do our split. So on $107, we're going to split 80/20. You can see the math here. We're taking this number times 0.8 and this number times 0.2. Now, if I total up how much the LPs are getting paid back, it's the equity payback plus $85 million for a total of $135 million. And us, the general partner, are making $21 million. Not too bad for 3 years. Plus, we're making $3 million from the management fees. Now, that might have paid for staff and other things, but in total, we're making just under $25 million on this Pretty cool. Our investors in 3 years did a 2.7x on their money or a multiple on invested capital. That's what that means there. MOIC with a simple IRR or rate of return of 91% per year. That's essentially just this number annualized per year. So well done. You guys crushed it. This is why people want to run funds. You can make this kind of money, $21 million on a $50 million fund. Which is a relatively small fund. By the way, the numbers like this scale. If you added a zero and you were a $500 million fund, the numbers work out pretty darn similar. There isn't a ton of growth things you have to do as a team to manage a $50 million versus a $500 million versus a $5 billion fund. Yes, staff goes up a little bit. Compliance costs go up. Yes, but it's not that drastic. This is why I believe running investment funds is the best business model on earth. Oh, and by the way, is the number one category of billionaires is private equity and investment fund management. This little thing, because you can see how much money you can make in just a few years, even running a relatively small fund. Now let's take a little bit deeper look at how the deal flow takes place inside of a private equity fund. On our example here, we doubled this company in a matter of 3 years. And this is where private equity managers make their big money is by doing something like like that. So here's the simple cycle. Number 1, they raise capital from LPs just like we described. Number 2, they find great companies that fit their investment thesis and they can add a ton of value to. Number 3, they buy the company using the fund's capital. Hopefully they get a good deal on it. Number 4, they improve the company. They use some of the leftover capital to inject into the company to get operational upgrades, cost efficiencies, leadership changes, expansion, debt restructuring, you name it. They improve the business like crazy. A lot great private equity people are great operators as well. They can come into a business and tweak a number of great things to grow it immensely. That's why they make the big bucks. And then finally, they sell the company for much more than they bought it and return capital and profits to investors and take some of the carry, the 20% like we talked about, for themselves. To break this cycle down even more, this is private equity in one sentence. They buy companies, they make them better, sell them, and then split the return returns and gains. This structure of funds with private equity works so well for 3 main reasons. Number 1, great alignment of interests. LPs get 80% of profits and GPs only get paid on the 20% when investors win and return their capital first. Number 2 is control. GPs control the fund, the deals, the strategy without interference. Limited partners are limited on their control, they're also limited on their exposure. This allows GPs to operate with autonomy within their investment thesis and strategy. And finally, number 3 is scalability once you prove performance. If you can do what I just described well on fund 1, there's a good chance you're raising a much bigger fund 2 and a fund 3 and a fund 4. Again, this is the number 1 category of billionaires on the Forbes 100 list because they proved this model again and again, and more people wanted to give them money to keep doing this over and over again. This is one of the cleanest, most powerful models in all of finance. And now you know how one operates. So if you like this video, please comment down below, like this video, and subscribe. It'll let us know that you want us to make more videos like this one. And share this video with a friend that maybe you want to go start a private equity fund with one day. So with that, thank you guys for watching, and we'll see you in the next one. Bye-bye.