How to start a private equity firm

At the highest level, the term “ private equity” describes the capital stock of any privately held company. Any investor who acquires some or all of the stock of a company that is not publicly traded is investing in private equity. 

However, as the field of private equity has matured over the past several decades, the terminology has grown more muddled. Today, private equity can still refer to the entire asset class of all private companies. More commonly, though, it refers to a specific niche of that broader asset class. 

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. 

For an investor, there are many similarities between starting a venture capital fund and establishing a private equity fund. But when in doubt, this article will use the more narrow definition: As we cover some of the key steps toward establishing a private equity firm, we’ll focus on the type of firm that primarily acquires controlling stakes in its portfolio companies through buyouts, bolt-ons, or other acquisition types. 

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 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. Some have tens of billions of dollars under management and hundreds of employees. Others are operated by a sole general partner (GP) who might be managing a few hundred thousand dollars. 

Because the landscape of private equity firms is so diverse, there are many potential ways to go about building and structuring a firm’s management and org chart. Some of they key roles that are often found at private equity firms include: 

• Managing director: The managing director determines the firm’s strategic direction and leads day-to-day operations, including sourcing deals, managing the portfolio, and maintaining investor relationships. 

• Principal: Principals source and lead investments throughout the transaction process, as well as other high-level operations tasks.

• Vice president: The VP of the firm oversees deal execution, including sourcing potential targets and negotiating terms, and manages more junior staff. 

• Associate: Associates prospect potential deals, conduct due diligence, create financial models (including waterfall models), and perform other tasks related to sourcing and supporting deals, including managing some transactions. 

• Analyst: Analysts conduct market research and provide support on potential deals, including financial analysis and modeling. 

• Advisors: Many young private equity firms rely on outside advisors to provide guidance and lend the firm some initial credibility. Advisors can be compensated through a salary or through exposure to the firm’s funds. 

Step 4: Draft a business plan

At some point in the process of legally forming a private equity firm, determining a strategy, and building a team, most firms will draft a formal business plan that details how the firm will operate and how it plans to manage its finances. A business plan for a PE firm should include a few key items:

• Executive summary: Provides a concise overview of your strategy and goals that will allow high-level decision makers and potential limited partners (LP) to quickly gain an understanding of your firm and how you plan to operate. 

• Market analysis: Analyzes the market and competitive landscape in the area where your fund intends to operate. 

• Team: Details the experience and qualifications of your firm’s team and how they related to the firm’s strategy, as well as any short-term plans for growth. 

• Financial projections: Provides projections for how your firm plans to raise capital, how much capital it plans to raise, and what sort of return profile it will aim to provide potential LPs. 

Step 5: Raise capital

After establishing the plan for how a private equity firm will raise capital from limited partners, it’s time to turn that plan into a reality. Fundraising is the lifeblood of any PE firm: Without capital, it’s impossible to make new investments. 

Identify investors 

The first step to raising capital is identifying potential LPs for your fund. At a high level, a PE firm might decide that certain types of investors would be a good fit as LPs, such as high-net-worth individuals, family offices, pension funds, or other institutional investors. Beyond those archetypes, this process also involves identifying individual LPs who might be interested in investing, based on factors such as the LP’s track record, their stated investment preferences, or personal relationships. 

Create a pitch deck 

A pitch deck is one of the standard tools that private equity firms use to market their funds to potential LPs and potential portfolio companies in a concise, informative format. It typically covers much of the same information that’s included in a firm’s business plan. 

Conduct a roadshow 

Raising capital for a private equity fund often involves pitching the fund to dozens or even hundreds of possible investors. When an investor is actively pitching a new fund, it often takes the form of an investor roadshow, with the investor making the rounds to present the opportunity to many potential prospects in a condensed period of time. A roadshow might involve physical travel to meet LPs in person, or it might be conducted virtually. 

Gather key documents

The process of raising capital from LPs can involve plenty of paperwork and documentation. Two of the most common examples are a private placement memorandum and a limited partnership agreement. 

Private placement memorandum (PPM)

The private placement memorandum is a marketing document that private equity firms create to provide information to potential LPs about a fund and its strategy. As a way to communicate the firm’s business plan, a PPM is often a key tool in the fundraising process.

Limited partnership agreement (LPA) 

The limited partnership agreement is a legal contract that outlines the terms of the relationship between a fund manager and an LP. Its purpose is to ensure that all parties fully understand and agree on the terms of investment. The LPA typically covers financial details related to an LP’s investment, governance procedures, and other key variables.  

Step 6: Conduct a first close

Most private equity firms begin the fundraising process with a target in mind of how much capital they’d like to raise from LPs. This target is usually for the final close of the fund, when it stops accepting new commitments. 

But fund managers might conduct multiple fund closings for a single fund. The initial close is known as the first close. Once a fund has its first close, the fund managers can begin sourcing new deals and writing checks. At the same time, they can continue to raise capital toward the final close. 

Begin capital calls

When LPs commit to a PE fund, they only pledge to provide capital in the future. Upon the first close, the fund manager can begin calling on those LPs to fulfill their pledge and wire cash to the fund’s accounts. This is known as calling capital or the drawdown process. The LPA typically defines a clear process for how the fund manager will make capital calls.

One purpose of holding a first close is that it allows a fund manager to begin proving the concept of their fund to other potential investors. Having a track record of recent investments to point to may be helpful in swaying some LPs to commit capital. A first close also allows the fund manager to begin using capital to pay expenses related to managing the fund, such as salaries and administrative expenses, which can be especially important for first-time fund managers.

Step 7: Source potential deals

The process of locating potential investments is called deal sourcing. One of the primary ways that private equity firms source potential deals is through their existing networks, which can include advisors, former colleagues, and other industry contacts. In other cases, PE firms source potential deals by soliciting pitches from companies. 

Regardless of how a firm sources potential investments, the next step of the process is to screen those prospects. Most private equity firms develop and employ a rigorous screening process to evaluate potential investments based on whatever criteria shape the firm’s investment strategy. 

Step 8: Conduct due diligence

Private equity firms and other investors often describe the process of screening potential portfolio companies as due diligence. To help determine whether an investment opportunity is attractive, firms typically look at a company from a few different angles: 

Financial analysis

A thorough financial analysis includes looking back at a company’s recent financial history and using modeling to project where it might go in the future. Some PE firms deploy proprietary financial models to determine whether a potential portfolio company fits in their framework.

Operational due diligence

PE firms also typically look at the operations of a target company, assessing how it functions on a day-to-day basis. In addition to helping inform whether a PE firm wants to invest, operational due diligence can also identify areas that might be ripe for improvement if the firm does decide to acquire a stake. 

Legal due diligence

Before deploying capital to a portfolio company, PE firms typically consult with legal professionals to determine whether the company is subject to any potential legal risks and what degree of exposure those risks might present to the firm. 

Step 9: Execute deals

If a private equity firm conducts its due diligence and decides it wants to invest in a company, the next steps are to negotiate and then eventually close the deal. Both the company and the firm typically work closely with their legal representatives at this stage. 

Negotiate transactions

The process of negotiating a private equity transaction can be complex, and different investments can take many different forms. Some of the key variables at play in a PE deal negotiation include:

• The size of the investment

• The structure of the investment

• The company’s valuation

• The role of the PE firm in company operations

• The role of the PE firm in company governance

Legal documentation

Once both the company and the investor agree on the terms discussed during deal negotiations, the two sides work with their respective legal representatives to draw up a contract outlining the terms of the sale and, if necessary, register the company’s new ownership structure with the relevant regulatory authorities. 

Step 10: Begin portfolio management

In some respects, sourcing and negotiating deals is the easy part. Once a private equity firm makes an investment, it begins the true work of partnering with the portfolio company to increase the company’s value so that the shareholders can eventually turn a profit. 

Operational improvements

The most basic way for a PE firm to create value at a portfolio company is to make operational improvements that allows the company to increase sales or function more efficiently. These improvements can take many forms, such as pursuing new markets, changing pricing strategy, or implementing new software.

Financial engineering

Private equity firms might also seek to create value by making financial changes at the company, such as taking on new debt, issuing dividends, or making other changes to the capital stack.

Portfolio monitoring

Whether a company has already implemented major changes or not, PE firms typically keep a close eye on portfolio performance across several key metrics and are constantly assessing whether adjustments are necessary. Most PE firms provide LPs with written portfolio updates at least once per quarter. 

Step 11: Model exit strategies

Private equity firms manage their portfolio companies with a goal in mind: achieving an exit, which allows the firm to recoup its initial investment and, ideally, return a profit. This can occur at any time, but most firms hold their portfolio companies for several years before an exit; somewhere between three and seven years is a common window. 

Exits are an imperative part of the PE lifecycle. By selling portfolio companies, PE firms generate capital that they are able to return to their LPs. This liquidity gives the LPs fresh capital to invest back into new PE funds, which will use the capital to invest in new companies, starting the cycle over again. 

IPOs

An initial public offering (IPO) occurs when a company lists its shares on a public stock exchange, making the transition from a private company to a public one. When a private equity firm exits a portfolio company, they sell some or all of the company’s shares to public investors, which can range from large mutual fund managers to individual retail traders. 

M&A

Mergers and acquisitions are a class of transaction in which one party purchases ownership of a company from another. There are two primary types of M&A deal through which a PE firm might exit a portfolio company: A corporate acquisition, in which the PE firm sells the target to another company, and a secondary buyout, in which the PE firm sells the target to a fellow private equity firm. 

Distributions

No matter the type of transaction, the purpose of an exit is to create liquid capital that the private equity firm can distribute back to its LPs. The limited partner agreement typically outlines the process through which LPs can expect distributions to occur. 

Step 12: Report financial performance

A private equity fund manager is a steward of their LPs’ capital. As such, providing regular updates to those VCs on the state of the portfolio is an important part of a fund manager’s job. 

Investor relations

Private equity firms often have one or more employees who focus on investor relations, which can be generally defined as the act of building and maintaining strong relationships with present and potential LPs. Providing transparent numbers on the performance of investments is usually a key aspect of these relationships. 

Quarterly reporting

Most private equity firms provide regular quarterly reports to the LPs in a fund. While these reports can vary in structure, they typically include performance metrics (such as TVPI and IRR) at both the fund level and the portfolio company level, as well as growth metrics and any other updates on financial performance and market conditions that might be useful to LPs. 

The next phase

The processes of developing a strategy, building a team, raising initial capital from LPs, and beginning to invest in portfolio companies are how a private equity firm establishes a foundation. Once these basics are covered, management can begin the day-to-day process of running the firm and, in many cases, scaling and growing the firm’s operations. 

Expand the team

Some private equity firms operate successfully for many years without ever growing their teams. Many other firms, though, continue to add more investors and support staff as the years go by. If a firm is successful, it will likely be able to raise larger pools of capital for future funds. Managing those larger pools of capital frequently requires more headcount. Private equity firms can vary widely in size, from a few individuals to hundreds of investors. 

Raise new funds 

At some point during the process of investing the capital from the initial fund, most private equity firms begin thinking about raising a second fund. If the initial fund has performed well and the firm has been maintaining their investor relations, LPs from the first fund may want to re-up their investment and commit to a second fund, as well. Raising a new fund also typically involves conducting a new roadshow to pitch the strategy to potential new LPs. 

At this point in the journey, a private equity firm has moved from infancy into adolescence. In the early days, the challenge is to establish a firm that can raise an initial fund and turn it into a success; if a firm succeeds in this mission, the next challenge is to do it again.