INVESTMENTS: How private equity firms are structured

This is the fourth part of our ongoing ten-part article series on the market, legal and regulatory perspectives of private equity in Tanzania. It focuses on the structuring of private equity (PE) firms. Understanding the structure of PE firms is helpful in discerning whether the firms would be a good fit for your needs when raising capital or selling your business.

Here’s a quick recap on what “private equity” refers to: medium to long-term capital invested in mostly unlisted (private) companies in return for ownership (equity) stakes. The capital is raised through partnerships which are managed by PE firms. Normally, PE firms comprise limited partners (“LP”) and general partners (“GPs”).

The LPs, consisting of institutional investors such as pension funds and high net worth individuals, provide the capital and their liability is limited to the capital they have contributed. Although no PE firm wants to have many LPs with small commitments, there usually isn’t a hard minimum contribution. Nevertheless, some LPs commit a minimum of $1 million (Sh2.3billion).

GPs obtain capital commitments from LPs and they professionally manage the PE fund, investing the pooled capital. GPs take control of the investment cycle. While LPs are not involved in deciding which companies to invest in (GPs do that), the LPs, if unhappy with the returns generated by the GP, may decide not invest with the PE fund again.

In part two of this ongoing article series, we learnt that the most PE firms are organized as limited liability partnerships (LLPs)—a structure that is currently not available under Tanzanian law—or company limited by shares or contractual type fund. PE funds have a finite lifespan of between 7 and 10 years, with 2 optional one-year extensions, but the lifespan generally doesn’t start until substantial capital is raised.

The stages that a fund goes through are: formation, raising capital and building a team, sourcing deal flow, managing and improving the portfolio, and exiting investments over varied time-frames. These stages overlap and so are the funds. Thus, as a PE firm raises a new fund, the firm may be managing and exiting from a previous fund.

By way of illustration, Mtuntwi Private Equity firm will raise the fund Mtuntwi Fund I and start sourcing deal flow and make investments (acquisitions). After some years and after the vast majority of the capital from Fund I has been invested, the firm will begin the process afresh and start fund raising Mtuntwi Fund II.

But then, how does the PE firm cover its operating expenses, such as, where applicable, salaries, research services, deal sourcing services, office space, marketing, travel costs, etc? To cover these expenses, the GPs charge a management fee from the LPs’ capital contribution. Generally, annual management fees are roughly 2 per cent of the fund size.

Let us revert to our illustration. Now, assume Mtuntwi Private Equity firm raised a $300 million fund with a 2 per cent management fee. Every year, the GPs would take $6 million of the LP’s capital to pay expenses. Therefore, over the 10 year life of the fund, the PE firm would collect $60 million from the LPs for expenses. Only $240 million of the $300 million fund would be, in reality, invested.

Besides the management fee, the GPs receive a part of the proceeds from the fund and this can be in the form of dividends, for example. The splitting of proceeds is governed by an agreement between the LPs and GPs. The part that GPs receive is known as the “carry” or “carried interest”. Carried interest is rather a niche topic and it has taken centre stage in parliamentary debates in many countries.

As a final point, the agreement between LPs and GPs will habitually include contractual provisions setting out what a PE firm can and cannot undertake. Key provisions include the lifespan of the fund, management fees for the fund manager, profit split method, and limitations imposed on the GP e.g. sector focus, size of investments, or geographical area of investments. PE funds often have limited partner advisory committees (LPACs) to help ensure the GPs motives are aligned to the investment objectives of the fund.

The author is the managing partner of Isidora & Company Advocates. The article continues next week.