Welcome to the World of Private Markets!
In this chapter, we dive into the heart of how private market deals actually happen. Think of this as going "behind the scenes" of a theater production. We have the General Partners (GPs) who are the directors and producers making things happen, and the Limited Partners (LPs) who are the investors providing the budget. By the end of these notes, you’ll understand how these two groups interact, how deals are found, and how the money flows. Don't worry if it feels like a lot of jargon at first—we'll break it down piece by piece!
1. The Players: GP vs. LP Perspectives
Before we look at the process, we need to know who is in the room. The relationship between the GP and the LP is the foundation of private markets.
The General Partner (GP) Perspective
The GP is the "doer." They are the investment firm (like a Private Equity or Venture Capital firm) that manages the fund. Their main goals are:
• Sourcing: Finding "diamonds in the rough" to buy.
• Value Creation: Fixing or growing the company to make it worth more.
• Exiting: Selling the company for a profit.
Quick Tip: The GP has "skin in the game" because they usually contribute a small amount of their own capital (often 1-5%) to show LPs they believe in the strategy.
The Investor (LP) Perspective
LPs are typically large institutions like pension funds, endowments, or wealthy individuals. They provide the bulk of the capital (95-99%). Their perspective is focused on:
• Strategic Allocation: How does this fund fit into their overall portfolio?
• Risk/Return: Are they being compensated enough for the fact that their money is "locked up" for 10 years?
• Due Diligence: Checking if the GP is actually as good as they say they are.
Key Takeaway: The GP manages the day-to-day work and takes the operational risks, while the LP provides the capital and takes the investment risk.
2. The Investment Process: From "Hello" to "Sold"
The investment process is often described as a "Deal Funnel." You start with a thousand ideas and end up with just a few great investments.
Step 1: Sourcing and Deal Flow
GPs don't just wait for the phone to ring. They actively hunt for deals through:
• Proactive Sourcing: Identifying industries they like and cold-calling owners.
• Reactive Sourcing: Investment banks bringing deals to them (auctions).
• Networking: Using their reputation to get "first look" at a deal.
Step 2: Screening and Preliminary Due Diligence
This is the "speed dating" phase. The GP looks at a Teaser (a short document) or an Information Memorandum to see if the company fits their criteria. If it looks good, they sign a Non-Disclosure Agreement (NDA) to see the "secret" data.
Step 3: Detailed Due Diligence
This is the most intense part. The GP hires accountants, lawyers, and consultants to check everything:
• Commercial DD: Is the market growing? Do customers like the product?
• Financial DD: Are the books accurate? (Checking Quality of Earnings).
• Legal DD: Are there any hidden lawsuits or ownership issues?
Step 4: The Investment Committee (IC)
Once the team is satisfied, they present the deal to the Investment Committee. This is a group of senior partners who act as the "gatekeepers." They ask the tough questions and give the final "Yes" or "No."
Quick Review: Think of the deal funnel like a job interview. Hundreds apply (Sourcing), some get a phone screen (Screening), a few do the full interview (Due Diligence), and finally, the boss decides who to hire (Investment Committee).
3. Economics: How Everyone Gets Paid
This is often the trickiest part for students, but it's just about following the "waterfall" of cash.
The Management Fee
This is paid to the GP every year to keep the lights on (salaries, travel, office rent). It is usually 1.5% to 2.0% of the committed capital.
Carried Interest ("Carry")
This is the GP’s reward for making a profit. It is usually 20% of the fund's profits. However, they usually only get this after they hit a Hurdle Rate (or Preferred Return), often around 8%.
Distribution Waterfalls
There are two main ways to split the money:
1. Deal-by-Deal (American): Profits are split as each individual company is sold. This is better for the GP because they get paid sooner.
2. Whole-of-Fund (European): The GP doesn't get a penny of carry until the LPs have received all their initial investment back plus the hurdle rate. This is much friendlier to the LP.
Analogy: Imagine a Deal-by-Deal waterfall is like getting a bonus for every goal you score in a soccer game. A Whole-of-Fund waterfall is like only getting a bonus if your team wins the entire championship trophy at the end of the season.
Formula Note: Total Return to LPs can be simplified as:
\( \text{Total Distributions} = \text{Initial Investment} + \text{Hurdle} + \text{GP Catch-up} + \text{Remaining Split (80/20)} \)
4. Monitoring and Value Creation
Once the deal is closed, the GP doesn't just sit back. They go to work! This is called Portfolio Management.
Active Management Strategies:
• Governance: Taking seats on the Board of Directors.
• Operations: Improving supply chains or cutting unnecessary costs.
• Buy-and-Build: Buying a small company and then buying even smaller companies to add to it (this is called add-on acquisitions).
Did you know? Modern Private Equity is less about "financial engineering" (using lots of debt) and much more about "operational improvement" than it was 30 years ago.
5. Exiting: The Grand Finale
The GP must sell the investment to realize the profit. There are four main paths:
1. Trade Sale (M&A): Selling the company to a big corporation (e.g., Disney buys a smaller studio).
2. Secondary Sale: Selling the company to another Private Equity firm.
3. IPO (Initial Public Offering): Listing the company on the stock exchange.
4. Recapitalization: Taking out a loan against the company to pay the investors a dividend (not a full exit, but a way to get cash out).
Key Takeaway: The "Trade Sale" is often the most common and provides a "clean break" for the GP.
6. Common Pitfalls to Avoid
Don't confuse Committed Capital with Called Capital:
• Committed Capital: The total amount an LP promises to give over the life of the fund.
• Called Capital (Drawdowns): The actual cash the LP has sent to the GP so far. Management fees are often calculated on committed capital early in the fund's life!
The J-Curve:
In the early years, a fund usually has negative returns because of fees and start-up costs. Don't panic! This is the "bottom" of the J-Curve. Returns should go up as companies are improved and sold later on.
Final Summary Quick Review
• GPs manage the money; LPs provide the money.
• The Investment Process moves from sourcing to due diligence to the Investment Committee.
• Economics are driven by the "2 and 20" model (2% fee, 20% carry).
• Waterfalls determine who gets paid first (LPs usually get their principal + hurdle first).
• Value is created through board seats and operational fixes, and realized through Exits like M&A or IPOs.
Keep going! You’ve just mastered the mechanics of how private market deals flow. If you can visualize the "deal funnel" and the "cash waterfall," you are well on your way to success in this section!