Step 1: Nail Down Your Corporate Structure#

Before you even think about finding investors or companies to buy, you must get your legal structure sorted out. As a smart fund manager, how your firm is legally set up is absolutely key.

Why? Well, it’s designed to be a bit complex on purpose. This complexity helps you minimize your personal risk, maximize your personal earnings, and handle all the complicated money rules effectively.

Your go-to move here is to form a Delaware limited partnership. You’ll be the general partner (GP) in this setup. Delaware is popular for this because of its legal benefits and flexibility. As the GP, you’ve got the power to make the big investment calls and manage the day-to-day stuff.

A super important piece of this is the Limited Partner Agreement (LPA). This is the contract between you, the GP, and your limited partners (LPs), who are basically your investors. The LPA covers everything – from your investment plans to how profits and losses are split up. It’s like the rulebook for the whole partnership, making sure everyone knows what’s happening. The LPA gives you, the GP, the power to guide the fund’s investments, but it also spells out your duties and how much authority you actually have. It’s all about balancing control with accountability.

Getting this structure, especially the LPA, right is crucial. It provides a stable base for running the fund and protects both you (the GP) and your investors (the LPs). Think about it: if you have too much control, nobody will want to trust you with their money. If you don’t have enough control, you won’t be able to run the fund properly.

• Real-world example: Remember that movie The Big Short? Christian Bale played Michael Burry. There’s a scene where a big investor argues with Burry, asking when other investors could pull their money out. Burry had made a super risky bet at that point that most investors weren’t on board with, so yeah, they really wanted out! But, Burry’s firm had clear rules about when you could withdraw, written right into their mandate. So, the investors were stuck until his investment paid off. If they had been able to pull out early, Burry would have had to close his positions, and everyone would have missed out on that massive win. So, see? This structure is absolutely essential for running your fund effectively.

• Don’t forget: On top of the partnership structure, you’ll want to add a management company. This company is technically separate from the main fund but works closely with it, advising both the fund and the companies you acquire. This is usually where you’ll find those sharp Harvard MBA analysts you’ll need to pay big bucks – think $250,000 a year before bonuses. Why? Because they’re the ones doing the heavy math and the due diligence (checking everything out thoroughly) to figure out if a company is a good investment or a bad one.

Oh, and while you’re setting all this up, make sure you or a trusted partner is named the Chairman and CEO.

Step 2: Raise Capital and Invest#

Now, remember, as a Private Equity General Partner, you’re essentially a middleman. You connect investors with potentially good investments. This step is maybe the simplest idea, but often the hardest part to actually do!

• You’ll be taking money from investors and using it to buy stakes in private companies (companies not on the stock market).

• Here’s the catch: those investors could make these private investments themselves. So, your main job is to convince them that giving their money to you is better because you can deliver better returns for them, even after you take your fees.

• Speaking of fees, they typically follow a “2 and 20” structure.

  • Your firm gets 2% of the assets you manage (AUM) every single year. This 2% is mainly used to pay the salaries of those expensive analysts and folks in your management company. After paying them, you might not have much left from this part.
  • That’s where the 20% comes in! This is your potential bonus. You get 20% of any profits or returns that are above a certain pre-agreed level. This level is called the hurdle. For example, if you and your investors agree the hurdle is a 10% return per year, but your firm makes 20% returns, you get to keep 20% of that extra 10% return for yourself as the General Partner.
  • This structure gives you a huge incentive to make big returns! You also want to manage as much money as possible because 20% of a bigger pie is, well, bigger! So, getting people to invest with you is a core part of the job.

• Getting Investors:

  • To start, you’ll likely need to put some of your own money into the fund. Unless you’re already loaded, this won’t be enough to buy whole companies. But it does two really important things:
    1. It shows other potential investors that you’re serious and have “skin in the game.” They’ll trust you more knowing your own money is also on the line.
    2. It sets you up for a nice little tax loophole, which means you could pay a lower tax rate than many Americans later on (we’ll get to that).
  • After putting in your money, you need to convince others to trust you. This is why it’s usually helpful to start a PE fund after you already have connections and experience in a specific industry.
  • No connections yet? Don’t sweat it entirely. You can also attract investors if you have deep experience in just one area. Let’s say you’ve spent years running hotel chains. You could start a PE firm that only invests in hotels and hospitality businesses. Sticking to what you know is smart – trying to buy a pharmaceutical company if you only know hotels could violate your Limited Partner Agreement and get you sued by investors! You just wouldn’t know how to run it.
  • Ultimately, the number one way to attract more investors is simple: make consistently high returns. Do this for long enough, and you might even have so many investors wanting in that you’ll have to turn them away!

• Finding and Buying Companies:

  • For now, you’ll start smaller with your first company acquisition. Your team of analysts from your management company will work with investment bankers. Think of investment bankers like real estate agents for businesses – they help people who want to sell their companies find buyers.
  • Your analysts will be looking for specific kinds of companies: those making a good profit with steady cash flow, in a stable industry, and where your PE firm sees clear ways to make improvements and boost profitability. And, based on what you told your investors (like only investing in hotels if that’s your niche), the deals must be in that industry.
  • The investment bankers also help find companies that are willing to sell at a reasonable price.
  • Once a potential company is found, your PE team and the investment bankers will draft an indication of interest and start the due diligence process – basically, kicking the tires and checking everything out thoroughly before buying.
  • Your PE team also starts talking to other investment bankers and private lenders (like banks) to get a loan to help pay for the deal. Why? Let’s say you only raised a modest $100 million** from investors, and the company you want to buy is also worth **$100 million. Buying it only with investor money means you’re betting your entire fund on one single company. That’s risky!
  • Instead, you show a bank that the company has stable profits and good cash flow, and you get a big loan – maybe $90 million** – to finance the purchase. Then, you use just **$10 million of the investor money to do the deal. This is called a Leverage Buyout (LBO) because you’re using a lot of debt (leverage) to buy the company. If you only used $10 million of investor money on this deal, you now have$90 million left and could potentially do this ten more times before using all the initial funds.

• Managing Your Portfolio Companies:

  • The companies you acquire this way are now called portfolio companies. Your main job is now to get as much money out of them as possible for your investors.
  • Private equity firms often get a bad rap for things like gutting companies, firing staff, and loading them up with debt. And yeah, they do this quite a bit.
  • Since you own these companies, you can tell their CEOs what to do. If a CEO doesn’t listen, you can just hire your own CEO who will follow your plan exactly.
  • What kind of plans? Here are a couple of common strategies PE managers use to boost returns from their portfolio companies:
    • Consolidation: If you own several hotels, you could combine operations like booking, housekeeping, administration, loyalty programs, or purchasing under one umbrella entity. This can save money (cut overhead) and potentially improve the customer experience by making things more consistent.
    • Cost Cutting: If consolidation feels too complex, you can always just use your analyst team to find parts of the business to cut expenses from.
    • Debt Paydown (Even Without Growth): You don’t only have to cut costs. You can simply use the acquired company’s own profits to pay down the big loan you took out (like that $90 million). Then, even if the company hasn’t grown much, you can sell it later. It’s kind of like buying a house, having a renter pay your mortgage for you, and then selling the house.
  • This kind of high-level business strategy isn’t free, remember. Even though the management fee (the 2% part) might seem small compared to potential investment returns, it’s still a lot of money, especially once you’re managing a portfolio of companies worth over a billion dollars.

Step 3: Exit the Investment (Get Paid!)#

By cutting costs and hopefully making your portfolio companies run better, their value should have gone up since you bought them. Now it’s time to turn those “on paper” gains into actual cash.

• The simplest way to do this is to sell the companies for a profit. You’ll likely work with another investment bank here, and they’ll usually give you a few options for selling:
  1. Take the company public again, either through an IPO (Initial Public Offering) or a SPAC (Special Purpose Acquisition Company). This sells the company to the general public via the stock market.
  2. Sell it to a strategic buyer. This is usually a bigger company in the same industry – like a larger hotel chain wanting to buy your portfolio of hotels. This is an acquisition.
  3. Sell it to another investor. This could be another private equity fund or perhaps a family office (wealthy family’s investment firm) that wants to keep growing the company.