Private Equity Industry Overview

• $4.7 trillion global business that minted more global billionaires than oil and technology
• Criticized for housing market impacts and corporate bankruptcies (Toys R Us example)
• Definition: Investment companies investing in assets not listed on public markets
• Types include:
  • Venture capital (early startups)
  • Alternative assets (airports, toll roads, IP rights, carbon credits)
  • Fund of funds (invest in other PE funds)
  • Buyout funds (focus of political/media criticism)

Step 1: Corporate Structure Setup

• Form Delaware limited partnership with general partner (GP) structure
  • GP has power for investment decisions and day-to-day operations
  • Delaware chosen for legal benefits and operational flexibility
• Limited Partner Agreement (LPA) requirements:
  • Contract outlining terms between GP and limited partners (investors)
  • Details investment strategies, profit distribution, loss allocations
  • Balances control with accountability
  • Includes withdrawal eligibility rules (Big Short example: Michael Burry's fund mandate prevented early withdrawals)
• Additional structure components:
  • Management company (technically separate from fund)
  • Provides advice to fund and acquired companies
  • Employs Harvard MBA analysts at $250,000/year before bonuses
  • Handle math and due diligence on investment opportunities
  • Appoint chairman and CEO positions

Step 2: Fundraising and Fee Structure

• Role as middleman between investors and good investments
• Standard "2 and 20" fee structure:
  • 2% of assets under management annually (pays analyst salaries)
  • 20% of returns over pre-agreed hurdle rate as bonus
  • Example: 10% hurdle rate, 20% returns = GP keeps 20% of additional 10% returns
• Fundraising requirements:
  • Must invest own money first to show commitment and create tax benefits
  • Need industry connections and experience
  • Alternative: deep industry expertise in specific sector (e.g., hotel chains)
  • Generate consistently high returns to attract more investors
• Investment process:
  • Analysts work with investment bankers (act as realtors for company sales)
  • Target companies with profit, good cash flow, stable industry
  • Must stay within LPA investment terms (e.g., hotels only)
  • Draft indication of interest and conduct due diligence

Step 3: Leverage Buyouts and Portfolio Management

• Financing strategy example:
  • $100M fund, $100M target company
  • Secure $90M loan based on target's stable profits/cash flow
  • Use $10M equity for leveraged buyout
  • Allows 10 deals instead of risking entire fund on one bet
• Portfolio company management strategies:
  • Consolidate operations across companies (booking, housekeeping, administration)
  • Cost-cutting measures: employee headcount, benefits, training
  • Use company profits to pay down acquisition debt
  • Appoint compliant CEOs if current management resists

Exit Strategies and Compensation

• Three exit options via investment banks:
  • IPO/SPAC to general public
  • Strategic buyer acquisition (larger hotel chain)
  • Sale to another investor (PE fund or family office)
• Tax advantages:
  • Carried interest loophole: profits taxed as capital gains (max 20%) vs income tax
  • Available because GP invests own capital in partnership structure
• Interest rate sensitivity:
  • PE operations sensitive to rate changes due to loan dependency
  • Contributing factor to current corporate bankruptcy boom

Industry Impact and Future Content

• Private equity stress contributing to corporate bankruptcy boom
• Upcoming content: entry-level PE employee guide and compensation expectations
• Available through free email newsletter subscription