Roles and Responsibilities of private equity (PE) firms & limited partner (LP) investors

Paul Johnstone

Roles and Responsibilities:

  • PE Firms:
    Private equity firms are the entities that actively manage and invest in private companies. They raise capital from LP investors to form private equity funds. PE firms are responsible for identifying investment opportunities, conducting due diligence, making investments in portfolio companies, and providing strategic guidance to enhance the performance of these companies.
  • LP Investors:
    Limited partners, on the other hand, are passive investors who provide the capital for private equity firms to invest. LPs typically include institutional investors such as pension funds, endowments, foundations, family offices, and high-net-worth individuals. Their primary role is to invest capital in private equity funds and trust the PE firm’s expertise to manage those investments.

Capital Contribution:

  • PE Firms:
    Private equity firms typically contribute a portion of the capital to their own funds, but the majority of the capital comes from LP investors. The PE firm’s contribution is known as the “general partner (GP) commitment,” and it aligns their interests with those of the LPs.
  • LP Investors:
    LP investors are the primary source of capital for private equity funds. They commit a specified amount of capital to the fund, which the PE firm then uses to make investments.


Decision-Making and Management:

  • PE Firms:
    PE firms have an active role in the decision-making and management of portfolio companies. They may have board seats, provide strategic guidance, and work to enhance the value of their investments.
  • LP Investors:
    LP investors typically do not have an active role in the management of portfolio companies. They entrust the PE firm with investment decisions and expect the firm to generate returns on their behalf.

Profit Sharing:

  • PE Firms:
    Private equity firms earn profits through various means, including carried interest, management fees, and potentially other fees. Carried interest is a share of the profits generated by the fund, typically around 20%, which is distributed to the PE firm’s partners.
  • LP Investors:
    LP investors receive returns on their investments based on the fund’s performance. They benefit from capital appreciation, distributions, and other returns generated by the investments made by the PE firm.

Liability and Risk:

  • PE Firms:
    The partners of the PE firm are generally responsible for the firm’s operations and may have personal liability. They also invest their own capital into the fund, aligning their interests with those of the LPs.
  • LP Investors:
    LP investors have limited liability. They are typically only responsible for their committed capital and are not personally liable for the actions or liabilities of the PE firm or its portfolio companies.

In summary, private equity firms are active managers responsible for sourcing, managing, and enhancing the value of investments, while LP investors are passive providers of capital seeking returns on their investments. Both play vital roles in the private equity ecosystem, with their interests and responsibilities often governed by detailed partnership agreements.


Types of investors

In addition to limited partner (LP) investors, private equity (PE) firms can have other types of investors or stakeholders, including institutional investors and sovereign wealth funds. Here’s how they differ:

Limited Partner (LP) Investors

Limited Partner (LP) investors play a crucial role in the world of private equity and venture capital investments. Here’s an overview of their roles, investment focus, and profit-sharing mechanisms:

Role:

  1. Capital Providers: LP investors are passive capital providers who contribute funds to private equity and venture capital funds. They are not involved in the day-to-day management of investments but entrust fund managers with the responsibility.
  2. Diversification: LP investors often allocate a portion of their investment portfolios to alternative asset classes like private equity to diversify risk and seek returns that may not be attainable through traditional investments.
  3. Risk Management: LP investors use private equity investments to manage risk and achieve specific investment objectives. For example, pension funds may use private equity to meet long-term retirement obligations.
  4. Alignment of Interests: LP investors seek alignment of interests with the fund managers (General Partners or GPs). They aim for the fund managers to work diligently to generate returns, as the GPs typically share in the profits.

Investment Focus:

  1. Diverse Investment Strategies: LP investors may allocate capital to a range of private equity strategies, including venture capital, growth equity, buyouts, distressed assets, and more. The specific strategies chosen depend on the LP’s risk tolerance and return objectives.
  • Geographic Focus: LP investors often have a global investment focus. They may allocate capital to funds targeting both domestic and international markets to capture opportunities and diversify risk.
  • Sector Agnostic or Specific: LP investors may choose to invest broadly across sectors or may have sector-specific preferences. For example, they might allocate capital to funds specializing in technology, healthcare, energy, or other industries.

Profit Sharing:

  1. Carried Interest: Carried interest, commonly referred to as the “carry,” is a significant profit-sharing mechanism for LP investors. It represents a percentage of the fund’s profits that is earned by the General Partners (fund managers) once certain performance thresholds are met. This arrangement aligns the interests of LP investors with those of the GPs, as both stand to benefit from the fund’s success.
  2. Distributions: LP investors receive their share of profits in the form of distributions. These distributions occur as the fund realizes returns through exits, such as selling portfolio companies or receiving dividends from them.
  3. Fees: LP investors also pay management fees to the fund managers for their services. These fees are typically calculated as a percentage of the fund’s assets under management (AUM) and contribute to the fund’s operational costs.

In summary, LP investors fulfill a crucial role in the private equity and venture capital ecosystem by providing capital, enabling diversification, and supporting various investment strategies. Their passive role as investors, coupled with the profit-sharing mechanisms like carried interest, ensures alignment of interests with fund managers and incentivizes both parties to work toward achieving strong investment returns.

Institutional Investors

Institutional investors, such as pension funds, endowments, foundations, insurance companies, and other large financial institutions, play a significant role in the world of private equity and investment. Here’s an overview of their roles, investment focus, and profit-sharing mechanisms:

Role:

  1. Capital Providers: Institutional investors serve as major sources of capital for private equity funds and various investment vehicles. They allocate a portion of their portfolio to alternative investments like private equity to diversify risk and seek potentially higher returns.
  2. Diversification: Institutional investors use private equity as a means of diversifying their investment portfolios. This asset class can provide exposure to different industries, strategies, and geographic regions, reducing the overall risk in their investment holdings.
  3. Risk Management: Institutional investors often have specific risk management objectives, such as meeting long-term liabilities (e.g., pension fund obligations) or preserving capital. They use private equity to balance their portfolios and manage risk.
  4. Due Diligence: Institutional investors conduct extensive due diligence before committing capital to private equity funds. They assess the track record, strategy, and risk profile of the fund managers to ensure alignment with their investment objectives.

Investment Focus:

  1. Diverse Investment Strategies: Institutional investors may invest across various private equity strategies, including venture capital, growth equity, buyouts, distressed assets, and more. Their allocation to different strategies depends on their risk tolerance, return objectives, and market conditions.
  2. Geographic Focus: Institutional investors often have a global investment focus. They may allocate capital to funds targeting both domestic and international markets to capture opportunities and diversify risk.
  3. Sector Specific: Some institutional investors may have sector-specific preferences, directing capital toward funds that focus on particular industries or sectors, such as technology, healthcare, or real estate.

Profit Sharing:

  1. Carried Interest: Institutional investors typically share profits with private equity fund managers through carried interest, commonly referred to as the “carry.” Carried interest is a percentage of the fund’s profits earned by the general partners (fund managers). This arrangement aligns the interests of institutional investors with those of the fund managers, as both benefit when the fund performs well.
  2. Distributions: Institutional investors receive their share of profits in the form of distributions. These distributions can occur as investments within the fund are exited and capital is returned to investors.
  3. Fees: Institutional investors also pay management fees to the fund managers for their services. These fees are typically calculated as a percentage of the assets under management (AUM). While they are not a profit-sharing mechanism, they contribute to the fund’s overall economics.

Institutional investors play a vital role in the private equity industry by providing significant capital, helping diversify portfolios, and supporting various investment strategies. Their rigorous due diligence processes and focus on risk management contribute to the stability and success of private equity investments. Profit sharing through carried interest aligns their interests with those of fund managers, incentivizing both parties to work toward achieving strong investment returns.


Sovereign Wealth Funds (SWFs):

Sovereign Wealth Funds (SWFs) are a distinct category of institutional investors with a specific role, investment focus, and profit-sharing approach in the world of private equity and investments:

Role of Sovereign Wealth Funds (SWFs) Investors:

  1. Asset Management: SWFs are state-owned investment funds established by governments to manage a country’s reserves and generate returns on those assets. Their primary role is to invest and grow the nation’s wealth.
  2. Economic Stabilization: SWFs often serve as mechanisms to stabilize the economy during times of commodity booms or other windfalls. They manage and invest revenues generated from sources such as oil, natural resources, or foreign exchange reserves.
  3. Diversification: SWFs aim to diversify their holdings to reduce dependence on a single revenue source, mitigate risk, and preserve wealth for future generations. They may invest in a wide range of asset classes, including equities, fixed income, real estate, and private equity.

Investment Focus of SWFs:

  1. Global Investment: SWFs typically have a global investment focus. They allocate capital across various regions and asset classes to capture opportunities worldwide and diversify their portfolios.
  2. Long-Term Perspective: SWFs often have a long-term investment horizon, which aligns with their goal of preserving and growing wealth over generations. This perspective allows them to invest in less liquid assets like private equity.
  3. Strategic Investments: SWFs may strategically invest in sectors or assets that align with their national interests or economic development goals. For example, they may invest in technology companies to support domestic innovation.

Profit Sharing with SWFs:

  1. Portfolio Returns: SWFs aim to generate returns on their investments, which are added to their overall portfolio. These returns contribute to the financial stability and wealth preservation objectives of the country
  2. Reserve Accumulation: The profits generated by SWFs can be used to accumulate reserves, strengthen the nation’s balance of payments, or finance government expenditures during economic downturns.
  3. Economic Development: SWFs may reinvest their profits in strategic sectors or projects that support the country’s economic development, infrastructure, or innovation initiatives.

In summary, Sovereign Wealth Funds (SWFs) fulfill a unique role in the global investment landscape, serving as stewards of a nation’s wealth and reserves. Their global investment focus, long-term perspective, and strategic approach to investments align with their objectives of wealth preservation, economic stabilization, and support for national development efforts. The profits generated by SWFs contribute to the financial well-being and resilience of the countries they represent.

The difference between PE & VC

Private Equity (PE) and Venture Capital (VC) are both forms of private investment, but they differ significantly in terms of their investment focus, stage of investment, and the types of companies they target.

Here are the key differences between PE and VC:

Investment Stage:

  • PE: Private equity firms invest in mature and established companies that are often looking for growth, expansion, or restructuring. These companies are typically beyond the early startup stage and have a proven track record of revenue and profitability.
  • VC: Venture capitalists, on the other hand, invest in early-stage and high-growth startups. They provide funding to help startups develop their products, enter the market, and scale rapidly. VCs often get involved during the seed, Series A, and Series B funding rounds.

Investment Focus:

  • PE: PE firms focus on a wide range of industries and sectors, including mature companies in manufacturing, services, real estate, and more. They often seek established businesses with predictable cash flows.
  • VC: VCs tend to concentrate on innovative and technology-driven startups in sectors like software, biotechnology, fintech, and consumer tech. They are willing to take higher risks in exchange for the potential of significant growth and returns.

Risk Tolerance:

  • PE: PE investments generally involve lower levels of risk compared to VC investments. PE firms often invest in companies with established business models and predictable revenue streams.
  • VC: VC investments carry higher risk due to the early-stage nature of the companies involved. Many startups fail, but successful investments can yield substantial returns.

Ownership and Control:

  • PE: PE firms often acquire a majority or controlling stake in the companies they invest in. They may actively participate in the management and decision-making processes of these companies.
  • VC: VCs typically acquire minority equity stakes in startups, providing capital and guidance but allowing the founders and management team to retain control and decision-making authority.

Investment Size:

  • PE: PE deals are generally larger in terms of investment size. They may involve millions to billions of dollars in funding.
  • VC: VC investments are typically smaller in comparison, with funding rounds often ranging from hundreds of thousands to tens of millions of dollars.

Exit Strategies:

  • PE: PE firms often seek exits through methods such as selling the company to another corporation, conducting a management buyout (MBO), or taking the company public (IPO).
  • VC: VCs look for exits that typically involve selling the startup to a larger company (acquisition) or taking the startup public through an IPO.

In summary, while both PE and VC involve private investment in companies, they differ significantly in terms of the stage of investment, risk tolerance, target industries, and investment size. PE focuses on mature companies seeking growth or restructuring, whereas VC focuses on early-stage startups with high growth potential. The choice between PE and VC depends on the investment objectives, risk tolerance, and the stage of development of the target companies.

 

Conclusion

In conclusion, the dynamics of the private investment landscape encompass a diverse array of participants, each with distinct roles and objectives.

Private Equity (PE) firms actively manage investments, while Limited Partner (LP) investors provide the crucial capital that drives these endeavours. LPs, comprising institutional investors and high-net-worth individuals, rely on PE firms to expertly manage their capital, with a shared goal of achieving returns.

Venture Capital (VC) investors, on the other hand, specialize in nurturing early-stage startups, embracing innovation, and targeting high-growth potential. VCs, often seen as enablers of entrepreneurial endeavors, align their interests with founders and startups to foster innovation and disruptive change.

This trio of investment participants—PE firms, LP investors, and VC investors—illustrates the multifaceted nature of private investments. Whether focusing on established companies, capitalizing on growth potential, or fostering innovation, these stakeholders collectively contribute to the dynamism and evolution of the broader financial landscape.

In essence, successful private equity and venture capital investments hinge on the collaboration, alignment of interests, and shared vision of these investors, emphasizing their pivotal roles in nurturing and advancing businesses across various industries and stages of development.