How to Start a Private Equity Firm

How to start a private equity firm

Author:

Kevin Dowd

| Read time: 12 minutes | Published date: September 20, 2024

Learn how to start a private equity firm—from defining your investment strategy to raising capital and conducting a first close.

Contents

Private equity vs. venture capital

Among most professional investors, the subset of private equity that involves making minority investments in smaller, younger private companies (like early-stage startups) is called venture capital. The strategy of buying majority stakes (or large minority stakes) in older, more established private companies is called private equity.

Thus, in one meaning of the term, venture capital is a type of private equity. In another meaning, the two could be considered distinct asset classes.

Step 1: Define your investment strategy

One of the first steps for a new private equity firm is to establish a strategy for how it will make investments. In nearly every case, a private equity fund’s investment strategy is guided at least in part by the background and expertise of its founder or founders. Some of the key variables that will define a private equity firm’s strategy include:

Transaction type

There are several different deal structures that are common among private equity firms, including leveraged buyouts (LBO), growth investments, and bolt-ons. Some firms specialize in one or more specific deal types.

Transaction size

Private equity transactions can vary widely in size, from less than a million dollars to several billion dollars. Transaction size is typically correlated to fund size, with smaller investment funds pursuing smaller deals.

Sector focus

Most private equity firms focus their activity on one or more business sectors. These are typically sectors where the firm’s leadership has some particular knowledge or strategic edge.

Value creation

The goal of a private equity firm is to acquire stakes in companies, work to make those companies more valuable, and then sell the stakes at a profit. Different firms have different strategies for how they aim to make their companies more valuable, often through some combination of operational improvements and financial engineering.

Investment risk

Some private equity investments have a higher risk of going bust than others. PE firms typically have well-defined guidelines for how they assess risk and how much potential risk they are willing to absorb.

Exit strategies

While it’s impossible to predict how or when an exit might occur, most private equity firms work with their portfolio companies (portcos) to achieve some sort of preferred outcome. IPOs, secondary buyouts, and sales to corporate buyers are the most common exit pathways for PE firms.

Step 2: Form a legal entity

In order to raise capital and make investments, a private equity firm must establish itself as a legal entity. Some of the key considerations at this point include:

Firm structure

Most private equity firms are established as general partnerships. This legal structure has several advantages for professional investors, including pass-through taxation and fewer regulatory requirements.

Firm registration

In the U.S., PE firms with more than $150 million in assets under management (AUM) must register with the Securities and Exchange Commission (SEC) as investment advisers. Smaller funds are generally not required to be registered investment advisers (RIA), but may still need to register with state regulators, depending on the jurisdiction.

Compliance

Private equity firms should be aware of all federal and state regulations that will govern their activity. Firms that are registered as investment advisors are subject to stricter regulations than other firms, including increased reporting and recordkeeping.

Step 3: Build your team

Private equity firms come in many different shapes and sizes, with various roles including:

Step 4: Draft a business plan

A business plan for a PE firm should include:

Step 5: Raise capital

Identify investors

The first step to raising capital is identifying potential limited partners (LPs) for your fund. Common types of investors include high-net-worth individuals, family offices, pension funds, and other institutional investors.

Create a pitch deck

A pitch deck is used to market funds to potential LPs and typically covers information included in a firm’s business plan.

Conduct a roadshow

Raising capital often involves pitching the fund to potential investors in either physical or virtual presentations.

Gather key documents

Raising capital can involve a private placement memorandum and a limited partnership agreement.

Step 6: Conduct a first close

Most private equity firms aim for a target amount to be raised from LPs as they begin the fundraising process. Once a firm has its first close, they can begin sourcing new deals and writing checks.

Begin capital calls

After the first close, fund managers can call on LPs to fulfill their capital pledge.

Step 7: Source potential deals

The process of locating potential investments is called deal sourcing and often involves using existing networks and soliciting pitches from companies.

Step 8: Conduct due diligence

Due diligence involves assessing financial, operational, and legal aspects of potential portfolio companies.

Financial analysis

Includes looking at a company’s recent financial history.

Operational due diligence

Assesses how the company functions on a day-to-day basis.

Legal due diligence

Identifies potential legal risks associated with an investment opportunity.

Step 9: Execute deals

Negotiating and closing deals involves discussions between the company and investor, working closely with legal representatives to outline the sale terms.

Negotiate transactions

Critical variables during negotiation include investment size, structure, and valuation.

Legal documentation

Contracts are drawn up to outline the terms of the sale and the new ownership structure.

Step 10: Begin portfolio management

Once an investment is made, the firm partners with the portfolio company to increase its value.

Operational improvements

Improvements may be needed to increase sales or efficiency.

Financial engineering

Creating value through changes to the company’s financial structure.

Step 11: Model exit strategies

PE firms aim to achieve an exit, often holding portfolio companies for three to seven years before selling.

IPOs

Occurs when a company lists its shares on a public stock exchange.

M&A

Includes selling to another company or a secondary buyout.

Distributions

Exit creates liquid capital that the PE firm can distribute back to its LPs.

Step 12: Report financial performance

Providing updates to LPs on the state of the portfolio is an important part of a fund manager’s job.

Investor relations

Building relationships with current and potential LPs, providing transparent performance updates.

Quarterly reporting

Regular reports typically include performance metrics and growth updates.

The next phase

As a private equity firm establishes itself, it may consider expanding its team and raising new funds for future investments.

Expand the team

As a firm grows, it may need more investors and support staff to manage a larger pool of capital.

Raise new funds

Successful firms often move on to raising a second fund, involving a new roadshow to attract additional LPs.

Author: Kevin Dowd