how equity investment firms work
There are many types of investment firms from very small firms that provide services for equity to seed funds to venture capital to growth equity to buyout private equity to public equity and hedge funds. For the purposes of our site, we will focus on investment firms that buy private equity not public equity (publicly traded stock). Most of these private equity firms have similar legal structures and staffing structures. Understanding how they work can help you understand how the entire investment industry works.
Basic Legal Structure
Investment firms are typically organized as limited partnerships, with two kinds of partners: limited partners and general partners. Limited partners (or LPs) are strictly investors in the investment firm and do not play any kind of management role. They provide the bulk of the capital available for the firm to invest. Limited partners are large institutions or very wealthy individuals. General partners (or GPs) actively manage the firm. GPs usually have backgrounds that qualify them to be able to select good investment. These backgrounds may include work in investment banking, consulting, private equity, venture capital, or running companies.
limited partners (LPs)
investment firmss typically raise money from large institutions or very wealthy individuals. Large institutions that might invest in a VC fund include pension funds, large banks, insurance companies, investment management companies, university endowments, and large non-profit organizations. These investors in VC funds are looking for the possiblitty of high returns over a long period of time and diversification.
Firms versus Funds
Investment firms raise capital into separate "Funds" and they deploy investments from these "Funds." So, for example, Kleiner Perkins, the investment firm, might raise a fund called Kleiner Perkins Fund VIII. Several years later, it might raise a nother fund called Kleiner Perkins Fund IX. It is tradition in the industy to use Roman Numerals to designate each fund. These funds become, in a sense, their own seperate investment businesses all managed by the parent company. Raising separate funds allow investment firms to constantly bring in new investors, manage different investors with different interests and timing requirements, and track performance by capital pools more easily. Funds are categorized, like bottles of wine, into vintage years. Vintage year refers to the year during which the fund started investing. So if Kleiner Perkins IX started investing in 2007, Kleiner Perkins IX has a 2007 vintage year.
Compensation Structure
investment firms receive two major types of compensation: management fee and carried interest (or "carry"). Management fee refers to an annual fee that is compensation for simply managing a pool of money on behalf of a set of investors. For the most part, investment firms receive this fee regardless of their performance as investors. This fee is typically 2%-2.5% of committed capital. So if a firm receives $200M in capital committments, it will generally receive $4M-$5M per year in management fee.
Carried interest refers to the share of profits that a investment firm receives. Most investment firms receive 20% of profits after repaying the amount of money they have raised plus interest plus management fee. So their investors, or limited partners, receive 80% of profits. If a investment firm raised $200M (with a 2% management fee) and managed the fund for 10 years, they would need to repay their investors $200M plus $40M (10 years of management fee at $4M / year) plus any accrued interest or preferred returns that the limited partners negotiated. In this case, we will assume that the interest or preferred returns are equal to $0. Now let's assume that after 10 years the investment firm has returned $440M by selling their equity stakes in companies. To see what carried interest the firm would receive we first need to subtract the principal plus accrued management fee, representing $240M. This leaves $200M in profits. At this point, the investment firm would get 20% or $40M and the investors would receive 80% or $160M.
The private equity compensation model is often referred to as 2 and 20.
staffing
Most investment firms will have partners (GPs) supported by a small set of investment professionals and a few back office personnel. The investment professionals have similar backgrounds as the GPs but tend to be younger in their careers. The back office personnel manage all of the administrative aspects of the office including HR, Finance, etc.