Hi team. In this video, you're going to learn how a private equity firm is structured. Private equity funds are closed-end investment vehicles, which means that there is a limited window to raise funds. And once this window is expired, no further funds can be raised.
These funds are generally formed as either a limited partnership or limited liability company. And the advantages of these structures for a private equity fund are primarily twofold. Perhaps the biggest advantage for investors is that they are exposed to limited liability.
If anything goes wrong in the investment process, bankruptcy, lawsuits, etc., the investor risks only the capital they have committed. And the second item is that limited partnerships and LLCs are pass-through entities for federal income tax purposes. I'll provide more information on this in the notes, but for now, let's move on to the description of the fund itself. Before any investments have been made, a private equity fund is simply a pool of capital.
The amount of capital committed to the fund but not yet allocated is frequently referred to in the industry as dry powder. and the team of investment professionals that will allocate this capital and the investors contributing the capital come together via the partnership agreement mentioned in the introduction. Per the partnership agreement, an investor secures an interest in the fund by contributing capital.
And here it's important to distinguish between the amount of capital committed by an investor and the timing of the overall capital contribution. It would be unusual for all of the capital to be funded at once, and it's far more likely that an investor will fund the commitment in response to several capital calls. A private equity firm will issue a capital call when investment opportunity has been identified and also to pay related fees and expenses. In most private equity funds, the investor's role is otherwise entirely passive.
It is the responsibility of the financial sponsor to source, acquire, manage, and divest the fund's investments. To make this a little easier to grasp, let's walk through an organizational chart with some definitions. To echo some of the comments about how a fund is established. Raising a private equity fund requires two groups of people.
First, you have the financial sponsor, which is the team of individuals that will identify, execute, and manage investments in privately held operating businesses. This is generally comprised of both a general partner and a management company. The general partner is the entity with the legal authority to make decisions for the fund. This entity also assumes all legal liability. And the management company is the operating entity that employs the investment professionals responsible for allocating capital and managing investments.
Next, you have your investors. These are the individuals that will provide the capital to make those investments. Because funds are generally formed as limited partnerships, investors are often referred to as limited partners.
In raising a fund, the fund founders will reach out to sources of institutional capital, such as pension plans and university endowments, as well as to high-net-worth family offices and individuals. The commitment to the fund, known as the capital commitment, will be made via a partnership agreement stipulating that the capital invested or resulting assets will be returned within a fixed period of time, typically not more than 10 years. A partnership agreement is a dense document, but superficially it will typically cover the following. The fund's mandate, which provides parameters for acceptable investments. These restrictions could relate to scale, geography, and security type, among other variables.
The fund term which defines the time horizons available for investment and divestment. Another important consideration is the management fee. This defines the fee tied to the capital raised or assets under management.
The management company will typically earn an annual fee in the range of 1% to 2% on AUM. And in some instances, the sponsor will charge fees to the portfolio companies directly as well. And finally, you have the distribution waterfall. Distribution waterfalls define the economic relationship between the general partner and limited partners. This is how the GP earns what is known as carried interest, which is typically 20% of the proceeds after the LP has received distributions equal to the original capital invested plus a defined preferred return.
This is covered in detail as part of the LBO video series, and you can find a link to this content just beneath the video player. Please be sure to see the notes as some of this can be difficult to grasp with the amount of new vocabulary introduced. I'll also include some additional detail concerning the contents of a partnership agreement.
All right, team. Thanks for watching. It's all for now.