This is my second post about information that you should be familiar with if interviewing for a role in Private Equity (the first was on valuation). The objective is to arm the uninitiated with information that will make you able to talk, if not like an expert, then at least like someone who is not a complete newcomer to the subject.
Like most financial topics, PE is rife with acronyms which often seem designed to close the subject to outsiders. If you are interviewing for a first job in the sector, you can get away with not knowing them all, but a bit of knowledge should prevent you from making unnecessary and potentially embarrassing mistakes and may help you stand out from the crowd.
Differences between General Partners (GP) vs Limited Partners (LP)
Two related acronyms that you will hear all the time in relation to private equity are GP and LP, which stand for General Partner and Limited Partner. Most (not all, but the vast majority) of PE funds are structured as Limited Partnerships for reasons that I have covered in previous posts. The distinction between GP and LP is an important one.
What is a Limited Partner?
Limited Partners are usually institutional or high net worth investors interested in receiving the income and capital gains associated with investing in the fund (these are not products designed for retail investors). They do not take part in the fund's active management and they are protected from losses beyond their original investment as well as any legal actions taken against the fund. When they agree to invest in the fund, they make a commitment to provide capital up to a fixed amount, as and when it is required (this is an important point – they do not pay in the whole amount on day one). Requests for capital are made when the fund is ready to make an investment – these are called draw-downs and will be made to all the fund's LPs pro-rata to their commitment. A failure to pay up when a draw-down is requested usually has serious consequences, so the LP has to ensure that they have cash or cash equivalents on hand to respond when required.
In addition, LPs often receive regular reports on the fund's performance, including capital account statements and quarterly reports. Understanding these reports is crucial, as they include key performance metrics like Internal Rate of Return (IRR) and Distributed to Paid-In Capital (DPI), which help LPs assess the success of their investment over time.
What is a General Partner?
The General Partners, on the other hand, are responsible for managing the investments within the fund (they may also be referred to as the fund sponsor or manager). These are the people who will be sitting in front of you at your interview and who you – presumably – hope to join. Unlike LPs, the General Partners are responsible for running the fund, and they are legally liable for the actions of the fund. For their services, GPs earn a management fee and a percentage of the fund's profits, called carried interest. In theory (not always in practice), the management fee is designed to cover the day-to-day running costs of the partnership and is calculated as a percentage (often 2%) of the capital committed by the LPs. The carried interest is what makes the job exciting and provides the GP with the opportunity to make serious money – if they do a good job and make significant profits, then they get to share those rewards, often up to 20%. It is, of course, a little more complicated than that – there will usually be something called a hurdle rate, which is a cumulative annual return – expressed as a percentage – which is paid to the LPs before any carry becomes payable to the GPs. After that, a formula will define exactly how the remaining proceeds are divided.
Key Performance Metrics
When interviewing for a PE role, it's important to understand the key metrics used to evaluate investment performance. The Internal Rate of Return (IRR) is a widely used metric that calculates the annualized effective compounded return rate on the invested capital, taking into account the timing of cash flows. Another essential performance indicator is the Multiple of Invested Capital (MOIC), which shows how many times over the invested capital has grown, providing a straightforward measure of the investment's absolute rate of return.
The Distributed to Paid-In Capital (DPI) measures the actual cash returned to LPs relative to the amount of capital they have contributed, indicating the realized returns. Conversely, the Total Value to Paid-In Capital (TVPI) includes both realized and unrealized value, combining DPI and the remaining value of the investments to assess the total performance of the fund.
The J-Curve Effect
Another concept you might come across is the J-Curve. In the early years of a private equity fund, returns often appear negative due to management fees and investment costs, while investments are not yet mature enough to generate significant returns. This forms the 'J' shape when plotting the fund's performance over time. Understanding the J-Curve effect is important, as it explains why early performance metrics may not fully reflect a fund's potential future returns.
Secondary Buyouts (SBOs) and Using Leverage
Private equity funds often use leverage to enhance returns. A Leveraged Buyout (LBO) is a transaction where a company is acquired using a significant amount of borrowed money, with the assets of the company often serving as collateral. Secondary Buyouts (SBOs) occur when a PE firm sells one of its portfolio companies to another PE firm, which is a common exit strategy. Understanding these terms can help you discuss investment strategies and exit options knowledgeably.
The DD (Due Diligence) Process & Why It's Important
Before making an investment, GPs conduct Due Diligence (DD) to thoroughly assess the target firm's financials, operations, market position, and potential risks. This process can include financial modeling, market analysis, legal checks, and operational assessments.
Preferred Returns and Catch-Up Clauses
In the context of carried interest and distributions, you might encounter terms like preferred return and catch-up clause. The preferred return, also known as the hurdle rate, is the minimum return LPs must receive before GPs can start receiving carried interest. The catch-up clause allows GPs to receive a higher share of the profits after LPs have received the preferred return, effectively 'catching up' to the agreed profit split.
Vintage Year and Fund Life Cycle
Understanding the concept of the vintage year is also important. The vintage year refers to the year in which a fund makes its first investment or when capital is first called from investors. The fund's performance is often compared to other funds of the same vintage year, as they face similar market conditions.
Private equity funds typically have a life cycle of around 10 years, with possible extensions. The fund's life cycle includes fundraising, an investment period (usually the first 3-5 years), management of investments, and an exit or liquidation phase.
Regulatory Considerations
Private equity firms operate under specific regulatory frameworks, depending on their jurisdiction. For example, in the United States, GPs may need to register with the Securities and Exchange Commission (SEC) under the Investment Advisers Act, and comply with regulations that govern fundraising, reporting, and investor protections. In the European Union, the Alternative Investment Fund Managers Directive (AIFMD) sets standards for marketing, risk management, and transparency. Being aware of regulatory requirements will showcase an interest of the industry for potential employers.
The Common Interests of GPs and LPs
The objective of carry is to align the interests of the GPs and the LPs. Another, additional, way of doing this is for the GPs to commit some of their own money to the fund (effectively as if they were also an LP). Many potential LPs will expect that 5% or so of the fund's committed capital should come from the GPs, which can make it difficult for first-time wannabe GPs to launch a fund, unless they are already wealthy individuals. On the other hand, an existing GP with a good track record will not only find it relatively easy to raise new funds but will also benefit enormously from their performance.
Closing Thoughts
Understanding this when you are sitting across the table from a GP in an interview should help you understand their motivation and expectations, as well as showing that you understand the basic structures of the industry. Ultimately, familiarizing yourself with these acronyms and terms will not only help you avoid awkward moments during your interview but also demonstrate a genuine interest and commitment to pursuing a career in private equity. It shows that you have taken the initiative to learn about the industry's unique terminology and complexities, which can set you apart from other candidates.
Good luck!
Like most financial topics, PE is rife with acronyms which often seem designed to close the subject to outsiders. If you are interviewing for a first job in the sector, you can get away with not knowing them all, but a bit of knowledge should prevent you from making unnecessary and potentially embarrassing mistakes and may help you stand out from the crowd.
Differences between General Partners (GP) vs Limited Partners (LP)
Two related acronyms that you will hear all the time in relation to private equity are GP and LP, which stand for General Partner and Limited Partner. Most (not all, but the vast majority) of PE funds are structured as Limited Partnerships for reasons that I have covered in previous posts. The distinction between GP and LP is an important one.
What is a Limited Partner?
Limited Partners are usually institutional or high net worth investors interested in receiving the income and capital gains associated with investing in the fund (these are not products designed for retail investors). They do not take part in the fund's active management and they are protected from losses beyond their original investment as well as any legal actions taken against the fund. When they agree to invest in the fund, they make a commitment to provide capital up to a fixed amount, as and when it is required (this is an important point – they do not pay in the whole amount on day one). Requests for capital are made when the fund is ready to make an investment – these are called draw-downs and will be made to all the fund's LPs pro-rata to their commitment. A failure to pay up when a draw-down is requested usually has serious consequences, so the LP has to ensure that they have cash or cash equivalents on hand to respond when required.
In addition, LPs often receive regular reports on the fund's performance, including capital account statements and quarterly reports. Understanding these reports is crucial, as they include key performance metrics like Internal Rate of Return (IRR) and Distributed to Paid-In Capital (DPI), which help LPs assess the success of their investment over time.
What is a General Partner?
The General Partners, on the other hand, are responsible for managing the investments within the fund (they may also be referred to as the fund sponsor or manager). These are the people who will be sitting in front of you at your interview and who you – presumably – hope to join. Unlike LPs, the General Partners are responsible for running the fund, and they are legally liable for the actions of the fund. For their services, GPs earn a management fee and a percentage of the fund's profits, called carried interest. In theory (not always in practice), the management fee is designed to cover the day-to-day running costs of the partnership and is calculated as a percentage (often 2%) of the capital committed by the LPs. The carried interest is what makes the job exciting and provides the GP with the opportunity to make serious money – if they do a good job and make significant profits, then they get to share those rewards, often up to 20%. It is, of course, a little more complicated than that – there will usually be something called a hurdle rate, which is a cumulative annual return – expressed as a percentage – which is paid to the LPs before any carry becomes payable to the GPs. After that, a formula will define exactly how the remaining proceeds are divided.
Key Performance Metrics
When interviewing for a PE role, it's important to understand the key metrics used to evaluate investment performance. The Internal Rate of Return (IRR) is a widely used metric that calculates the annualized effective compounded return rate on the invested capital, taking into account the timing of cash flows. Another essential performance indicator is the Multiple of Invested Capital (MOIC), which shows how many times over the invested capital has grown, providing a straightforward measure of the investment's absolute rate of return.
The Distributed to Paid-In Capital (DPI) measures the actual cash returned to LPs relative to the amount of capital they have contributed, indicating the realized returns. Conversely, the Total Value to Paid-In Capital (TVPI) includes both realized and unrealized value, combining DPI and the remaining value of the investments to assess the total performance of the fund.
The J-Curve Effect
Another concept you might come across is the J-Curve. In the early years of a private equity fund, returns often appear negative due to management fees and investment costs, while investments are not yet mature enough to generate significant returns. This forms the 'J' shape when plotting the fund's performance over time. Understanding the J-Curve effect is important, as it explains why early performance metrics may not fully reflect a fund's potential future returns.
Secondary Buyouts (SBOs) and Using Leverage
Private equity funds often use leverage to enhance returns. A Leveraged Buyout (LBO) is a transaction where a company is acquired using a significant amount of borrowed money, with the assets of the company often serving as collateral. Secondary Buyouts (SBOs) occur when a PE firm sells one of its portfolio companies to another PE firm, which is a common exit strategy. Understanding these terms can help you discuss investment strategies and exit options knowledgeably.
The DD (Due Diligence) Process & Why It's Important
Before making an investment, GPs conduct Due Diligence (DD) to thoroughly assess the target firm's financials, operations, market position, and potential risks. This process can include financial modeling, market analysis, legal checks, and operational assessments.
Preferred Returns and Catch-Up Clauses
In the context of carried interest and distributions, you might encounter terms like preferred return and catch-up clause. The preferred return, also known as the hurdle rate, is the minimum return LPs must receive before GPs can start receiving carried interest. The catch-up clause allows GPs to receive a higher share of the profits after LPs have received the preferred return, effectively 'catching up' to the agreed profit split.
Vintage Year and Fund Life Cycle
Understanding the concept of the vintage year is also important. The vintage year refers to the year in which a fund makes its first investment or when capital is first called from investors. The fund's performance is often compared to other funds of the same vintage year, as they face similar market conditions.
Private equity funds typically have a life cycle of around 10 years, with possible extensions. The fund's life cycle includes fundraising, an investment period (usually the first 3-5 years), management of investments, and an exit or liquidation phase.
Regulatory Considerations
Private equity firms operate under specific regulatory frameworks, depending on their jurisdiction. For example, in the United States, GPs may need to register with the Securities and Exchange Commission (SEC) under the Investment Advisers Act, and comply with regulations that govern fundraising, reporting, and investor protections. In the European Union, the Alternative Investment Fund Managers Directive (AIFMD) sets standards for marketing, risk management, and transparency. Being aware of regulatory requirements will showcase an interest of the industry for potential employers.
The Common Interests of GPs and LPs
The objective of carry is to align the interests of the GPs and the LPs. Another, additional, way of doing this is for the GPs to commit some of their own money to the fund (effectively as if they were also an LP). Many potential LPs will expect that 5% or so of the fund's committed capital should come from the GPs, which can make it difficult for first-time wannabe GPs to launch a fund, unless they are already wealthy individuals. On the other hand, an existing GP with a good track record will not only find it relatively easy to raise new funds but will also benefit enormously from their performance.
Closing Thoughts
Understanding this when you are sitting across the table from a GP in an interview should help you understand their motivation and expectations, as well as showing that you understand the basic structures of the industry. Ultimately, familiarizing yourself with these acronyms and terms will not only help you avoid awkward moments during your interview but also demonstrate a genuine interest and commitment to pursuing a career in private equity. It shows that you have taken the initiative to learn about the industry's unique terminology and complexities, which can set you apart from other candidates.
Good luck!