How to Start a Private Equity Firm

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The private equity industry has steadily expanded, as it has continuously proved to be one of the most successful asset classes. According to some estimates, more than a third of junior investment bankers who started two-year positions in 2012 have since transitioned to private equity. Over the past three decades, private equity has outperformed the Standard & Poor’s 500, which has significantly increased demand for private equity funds from both institutional and individual accredited investors.

With demand still increasing, more private equity managers are needed. The question then becomes: How does a manager launch a private equity fund?

Writing a Business Plan for a Private Equity Fund

business planThe first step in launching a private equity fund is creating a business plan. The business plan allows managers to account for the costs, risks, and challenges of establishing the fund while also helping to define what managers intend to do with any money that is invested into the fund. When writing a business plan, individuals should outline cash flow expectations and create a realistic timeline for raising capital, making investments, and exiting those investments. A typical private equity fund has a lifespan of about 10 years, but this decision is largely up to the manager establishing it. Regardless of the timeline, the business plan should convincingly explain how the fund plans to grow over time. Growth outlines should include marketing plans to attract investor interest.

Before managers can decide on a marketing plan, they need to have a clear conception of the firm’s business strategy. This strategy is what differentiates the fund from competitors, and it should reflect considerable time spent researching relevant markets and sectors. Most funds will focus on specific industries, such as clean energy or biotech startups, and some even have a geographic focus. All of these decisions will affect which investors the fund will attract and the various tactics used to convince them to invest.

Establishing Operations and the Investment Vehicle

With a solid business plan written, managers next need to focus on operations and building a team of excellent external consultants that can support the fund. These professionals should include independent accountants, industry experts, and attorneys. The investment industry is dominated by complicated legal and regulatory frameworks, so it is important to find attorneys with experience navigating these requirements. Regulations apply to everything from fund marketing to accepting money. Finding the right experts is typically not cheap, and forming the right team can require an initial investment of hundreds of thousands of dollars.

With this team in place, it’s time to establish the firm and name the fund, and to decide on the roles and titles of the organization’s leadership. First-time managers should establish a core team that consists of people with successful investment experience to convince investors of the firm’s legitimacy. Managers may also want to create an advisory board and think about disaster recovery strategies for situations ranging from cyber-attacks to unexpected and steep market downturns.

dollarFunds in the United States generally assume limited partnership or limited liability structures. Founders become general partners and decide which investments make up the fund. Investors play the role of limited partners and do not have this decision-making power. Limited partners remain accountable for losses in scale to their individual investments, while general partners are accountable for any additional losses. Attorneys are needed to draft private placement memoranda and other operating agreements.

New firms also need to determine the best fee structure. Usually, private equity managers earn an annual management fee of 2 percent of committed capital, but less experienced fund managers may set the percentage lower to attract more investors. Carried interest is most frequently set at 20 percent above expected levels of return. Compliance, valuation, and risk guidelines should also be laid out clearly at this point.

Raising Investment Capital

Before engaging with investors, fund managers should make sure they have all necessary paperwork prepared, which could include subscription agreements, offering memoranda, custody agreements, partnership terms, and information about due diligence policies. Managers will also need marketing collateral and a proper severance letter from any previous employer, so that they can legally discuss their investing track record. With all this information in order, managers then face the biggest challenging of starting a private equity fund: convincing other people to invest.

Typically, the first investment comes from the fund manager, especially if that person has already had a successful career. Most investors want to see an investment of at least 2 to 3 percent of total capital commitments from the manager. Beyond that, federal regulations hold that only institutional and accredited investors can provide capital to private equity funds. Typical investor targets include sovereign wealth funds, pension programs, university endowments, and financial institutions. To become an accredited investor, individuals need to meet a minimum annual income threshold of $200,000 for two years in a row, or have a net worth in excess of $1 million.

Raising funds requires a great deal of work and diligence. Managers typically need to hit the road and pitch to whichever potential investors will hear them out while maintaining the stamina needed to keep going. Thousands of alternatives exist in the investing world, so it is critical that managers understand how to explain why their fund is the best option.


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