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Where do VC and PE funds get their money?

Our clients often ask us where venture capital funds (VC) and private equity funds (PE) get their money. This is an important question, because if you understand a buyers’ source of funds, you can better understand how a buyer might behave during a negotiation.

These funds use other organisations and individuals’ money. They are set up such that the money is held in one entity, but the private equity/venture capital (lets call this PEVC for short) management team operate out of another.

PEVC management teams canvass many big organisations who need to have funds invested. These organisations are often Australia’s superannuation funds, US 401(k) funds, union funds (who has heard of the Ontario Teachers’ Fund?) and sovereign funds. Each of these funds allocate a certain percentage to the PEVC asset class. Often its 10% or more.

The PEVC management team visit and lobby these big sources of funding to get them to legally pledge part of their allocation to their particular PEVC fund.

Once a big fund agrees to allocate part of its funds to a particular PEVC management team, an agreement is struck that stipulates that the big fund holds some money on an at call account, ready to deposit into the PEVC fund, when the PEVC finds and consummates a deal.

This investment from the big fund into the PEVC fund labels the big fund a “limited partner of LP” and the PEVC management team is given the label “General Partners or GPs”. You’ll often hear about ‘limiteds’ or ‘generals’ in the lingo.

So, when the GPs spend the LPs money, there’s also an agreement of how, in the end, the resulting spoils of the investment are split.

Its often called the 8/20 rule, noting that the principal and the first 8% of the compounded annual growth of the investment goes to back to the LP and the remainder is split 20% to the GP, 80% to the LP. This can vary, but you get the idea. So you can see, with multi billion dollar funds, GPs as individuals can make a lot of money if they do well.

GPs do receive part of the fund (up to 2%) annually to fund their own management and financial analyst team who actually go out and chase the deals.

Finally, PEVC funds have drop dead dates, often 10 years after start. You should know or get your advisor to find out how old the fund is, because that will tell you how much time they have to hold your business, if they buy it.

So next time you’re introduced to a private equity/venture capital (PEVC), ask about when their pioneer year was so you can easily know where they are in their life cycle. Needless to say, PEVC like buying in years 1-3, consolidating/growing in years 4-7 and selling in years 8-10, broadly speaking.

Knowing a buyers' source of funds, you can better understand their motivations and how a buyer might behave during a negotiation.

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