Limited partners (LPs), typically large institutional investors like pension funds and endowments, provide the bulk of capital for private equity funds. LPs receive regular income from management fees, but the real upside is the share of profits through carried interest. When evaluating PE funds, LPs focus on the fund manager’s track record, investment strategy, deal pipeline, and team dynamics. LPs diversify across stages, geographies, and sectors to optimize risk-adjusted returns. Proper due diligence and thoughtful portfolio construction are vital for long-term PE investing success.
LPs as major source of capital in private equity industry
LPs, such as public pension funds, corporate pension funds, insurance companies, endowments, foundations, and high net worth individuals, provide most of the capital for private equity funds, typically 95% or more. They commit this capital upfront when the fund is formed. The private equity firm serves as the General Partner (GP) and contributes a smaller amount, such as 5%. The GP makes the actual investments in private companies and manages the portfolio.
Two major components of LP compensation
LPs receive two main forms of compensation – management fees and carried interest. Management fees, around 1.5-2%, provide steady current income to cover operating expenses. Carried interest, typically 20% above a hurdle rate, allows LPs to share in the profits if the fund performs well. Upside can be substantial, but there is risk since carried interest depends on successful exits.
Due diligence factors for selecting PE funds
When evaluating PE funds, LPs focus on the fund manager’s historical track record, consistency of returns across vintages, investment strategy and philosophy, deal sourcing and pipeline, team dynamics and leadership, and alignment of interest through co-investments. LPs want seasoned partners with expertise in their sectors.
Portfolio construction considerations for LPs
LPs aim to mitigate risk through diversification across stages, sectors, geographies, and vintages when constructing their PE portfolio. Most allocate to a blend of venture capital, growth equity, buyout, and special situations funds. LPs monitor their target allocation bands and rebalance as needed. They favor managers with disciplined investment processes.
Long-term orientation critical for LP success
Given the 10+ year lifespan of most PE funds, LPs must take a long-term approach to investing. Private equity’s illiquidity, J-curve dynamics, and long exit timeframes reinforce the need for patience. LPs focus on net returns over multiple funds and cycles, not short-term performance. Aligning interests via co-investments aids retention of top LPs.
In private equity, LPs serve as the major providers of capital while GPs manage the funds. LPs receive management fees for steady income and carried interest for profits. Thoughtful due diligence on factors like track record and deal pipeline guides fund selection. Portfolio diversification across stages, sectors, and geographies balances risk and return. Long holding periods and illiquidity necessitate an extended outlook. With proper alignment of interests, LPs and GPs can build enduring partnerships.