What is Private Equity anyway?
In relation to a hedge fund, Private Equity is basically when a fund will invest in privately owned businesses.
They will purchase these businesses and then have a turnaround period where they will look to improve them.
Then once they increase the cashflows and processes of that business they can sell it at a later time for a huge profit.
So let’s talk about how they do that exactly.
How do Private Equity Funds Work?
Private Equity Funds use a similar fund model to other funds,
Such as Hedge Funds, Real Estate Funds, Venture Funds, etc…
First you have a General Partner, or Fund Manager, who will go and raise money from investors.
The capital from the investors is put into what is called a Limited Partnership.
The Fund Manager then invests the money from the Limited Partnership by using a General Partnership.
In a Private Equity Fund, the money is invested into Private Businesses and the profits are then returned to the Limited Partnership and split between investors and the fund manager.
When the fund makes profit from the cash flows or the sale of the acquired company, those profits are returned to the Limited Partnership.
That money is then split between the General Partner and the Investors.
How does the capital requirement work?
For Private Equity Funds the General Partner will include stipulations within the fund documents themselves.
One of the requirements is typically a minimum amount of money that you would have to invest into the fund.
Some funds require $100k, some $1 million, or in Ray Dalio’s funds…
(And a net worth of at least $5 Billion.)
That’s a lot of dough.
So how are these profits split?
In reality the profit split of the fund is completely up to the discretion of the General Partner.
However, if you expect to take home 80% of the profits then you probably will have a hard time convincing investors.
Typically Private Equity Funds do what is called a 2/20 split.
The 2 means a 2% management fee off of the top,
And the 20 means a 20% split of all profits after the pref rate is surpassed.
Wait, what’s is a pref rate?
Pref rate, also known as a hurdle rate, stands for preferred rate.
This is the rate at which investors get to keep all the profits.
This rate depends on the type of fund you are running but let’s say a usual pref rate is about 8%.
Meaning that investors get to keep the first 8% of the returns.
After that, the profits are then split 80%/20% with the fund manager taking home the latter.
Ray Dalio requires a $100 million dollar investment for his fund.
He takes on 10 investors.
This makes the amount of money in the Limited Partnership $1 Billion.
Ray gets a 2% management fee off of the top.
A cool $20 Million.
The fund then returns 14%.
8% of that, or $80 Million, would go directly to investors.
The next 4%, or $40 Million, Would be split 80/20.
$32 Million to investors and $8 Million to Ray.
Ray walks away with $28 Million that year alone.
Does that make sense?
Now that was an extreme example but you see that point that funds can be a great way to build wealth.
And luckily you don’t have to be Ray Dalio to run a fund.
I run funds and I am nowhere close to as smart as he is.
But over the years I have gotten better and now deploy millions of dollars.
If you want to learn more about Private Equity for free then click on the YouTube Video above.
I go into much greater detail there.
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DISCLAIMER: This content is for educational and informational purposes only. It is not to be taken as tax, financial, or legal advice. You should always consult a legal professional before taking action. Furthermore, this is not a recommendation to buy or sell any security. The content is solely just the opinion of the authors.