Starting a private equity firm the right way is important. If you get it wrong the first time, it could result in huge (unrecoverable) losses for you as an investor and entrepreneur. That’s why we thought it would only make sense to reach out to experts in the private equity industry to help us answer the questions related to starting a private equity firm. We reached out to a well-known player in the private equity industry to assist, Jeff Paul Thomas.
Jeff is currently the Entrepreneurship Chairperson & MET Program Director at Central Michigan University, Jeff also worked in Chicago and Silicon Valley as an Attorney. His Harvard Law education has enabled him to provide consulting and advice to entrepreneurs in the areas of intellectual property matters, venture capital financing, angel investments and business formations. In addition, he started an internet company that was created to help attorneys seeking alternative careers.
Which type of business entity should one choose when starting a private equity firm? Why?
The business entity question is actually more applicable to the funds that private equity (PE) firms use to make investments in their portfolio companies. Typically, PE firms form these funds as limited partnerships. More specifically, Delaware limited partnerships. By definition, limited partnerships must have at least one general partner (GP) and at least one limited partner (LP). The GP is usually another entity (e.g., an LLC or another limited partnership) that is owned and controlled by the PE firm’s principals. The GP actively manages the fund whereas the LPs are passive investors in the fund. The fund’s limited partnership structure provides pass-through taxation and limited liability to fund’s investors.
That is, the limited partnership entity does not pay any federal income taxes itself. Instead, the taxable income will pass through to the fund’s owners and these LPs can only “lose” what they chose invest into the fund. Also, by forming another limited liability entity to serve as the GP, the PE firm and its principals limit their liability exposure as well. Delaware is a popular choice for jurisdiction because, among other things, many GPs, LPs, and attorneys are familiar with Delaware’s law – and often have forms/documents/templates they used in previous deals (where Delaware was the jurisdiction) that can be “recycled” for their current deal.
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How much funds should you have when starting a private equity firm?
You will want to have enough funds to pay the expenses associated with forming the fund (e.g., legal fees), going out to raise capital from the LPs (e.g., traveling to pitch potential LPs), and the managing firm (e.g., covering salaries, rent, and marketing expenses incurred before the fund is able to generate “management fees” – as an FYI, annual management fees will be around 2% of the fund’s size). Of course, the fund will also need to have enough capital to make desired investments in its portfolio companies (both initial investments and any follow on investments). However, the LPs will be responsible for putting their money into the fund after they receive “capital calls” from the GP. That is, PE funds typically do NOT raise all of their capital upfront from the LPs and then put the money into a bank account.
Instead, they have the LPs contractually commit (through the Limited Partnership agreement) to contribute their committed capital at a later date, when asked by the GP to do so (i.e., after desired investments have been identified). Regardless, as one of our MET program advisors, Johnathan Robertson (President & Managing Director at TG Capital) shared with me, the amount of funds a PE firm will eventually need to raise/call will depend on the PE firm’s strategy: their target investment size, their expected equity coverage ratio, and the amount of capital they reserve for add-ons. He also shared this great example: if the PE fund intends to buy 5 companies in their initial fund each with a $50-$100mm valuation range and expects to invest 30% equity per investment, and reserve an additional 30% for add-ons, then they would need to raise approximately $150mm (as summarized below):
| Low | High | Average | x5 Investments | |
| Valuation Range/Investment | $50mm | $75mm | $100mm | |
| Equity Coverage | 30% | 30% | 30% | |
| Initial Investment Range | $15mm | $30mm | $22.5mm | $112.5mm |
| 30% Add-On Reserves | $146.25mm |
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Is it worth it to start a private equity firm or do you recommend an alternative for investors?
It depends. Starting a private equity firm may require hiring several smart and hardworking professionals, working long hours, and making tough decisions. It could also provide several financial (see below) and non-financial rewards (such as positively impacting an important industry). Alternatives might include forming a venture capital firm or an angel investment group to make smaller investments in private companies (often younger companies). Other ways to invest in private companies may include becoming a member of an angel investment group or participating in crowdfunding (e.g., rewards-based or equity crowdfunding).
The pros, cons and benefits of starting a private equity firm for investors.
Financial incentives are certainly some of the potential pros and benefits associated with starting a PE firm. In short, a GP’s “carry” (a/k/a “carried interest”) is often 20% of the fund’s profits. Thus, a GP can raise capital from LPs, put that capital to work (by investing the capital into portfolio companies), make important value-creating changes at the portfolio companies (e.g., by adopting more effective strategies), then cash-out (by selling the portfolio company investments at substantial gains), then return investments previously made by the LPs, and then take 20% of what’s left – and have that gain (a/k/a carry or carried interest) taxed a favorable (low) tax rate. Potential cons include things not going so smoothly and the long hours/stress that will be required to overcome the challenges that are certain to arise along the way.
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