PE Fund Mechanics

Who is in a fund

A private equity fund is usually a limited partnership. Limited partners (LPs) — pension funds, endowments, sovereign wealth funds, insurers, family offices — commit capital. The general partner (GP), the PE firm, makes and manages the investments and usually commits 1–5% itself.

Life of a fund

• Fundraising — LPs sign commitments; nothing is paid up front.
• Investment period (about 5 years) — the GP makes capital calls as deals close.
• Harvest period — portfolio companies are improved and exited; proceeds are distributed.
• Fund life — typically 10 years plus extensions.

Early on, fees and write-downs make returns negative before exits arrive — the J-curve.

Fees and carry: "2 and 20"

• Management fee — roughly 1.5–2% a year of committed capital during the investment period, often stepping down to invested capital afterwards. It pays for the GP's team and operations.
• Carried interest — the GP's share of profits, typically 20%, earned only after LPs get their capital back plus a preferred return (hurdle), commonly 8% a year.

The distribution waterfall

1. Return of capital to LPs.
2. Preferred return to LPs (the hurdle).
3. GP catch-up until the GP has received 20% of profits so far.
4. 80 / 20 split thereafter.

A European (whole-fund) waterfall applies this to the fund as a whole; an American (deal-by-deal) waterfall pays carry deal by deal and usually has a clawback in case later deals lose money.

Worked example

LPs contribute 1,000 and the fund returns 1,800 in total. Profit = 800. The hurdle is cleared and there is a full catch-up, so the GP's carry = 20% × 800 = 160 and LPs receive 1,640 — a net multiple of 1.64x before fees versus a gross 1.8x.

Measuring performance

MOIC vs IRR: MOIC measures how much money you made; IRR measures how fast. A quick flip can have a high IRR but a low MOIC; a long hold can have a high MOIC but a modest IRR. LPs want both, and increasingly care about DPI.

Why dividend recaps and quick exits matter

A dividend recap borrows at the portfolio company to pay the fund a dividend. It returns cash early, which raises IRR and DPI without an exit, at the cost of more leverage on the company.

Interview angles

1. "How does a PE firm make money?" Fees plus carry, and carry depends on beating the hurdle.
2. "Why might a GP prefer IRR over MOIC?" Carry and fundraising track IRR, but a very short hold may not return enough absolute dollars.
3. "Gross vs net returns?" Net returns are after fees and carry — what LPs actually earn.

From idea to investment committee

Before a sponsor bids, the deal team writes an investment thesis and tests it through diligence. The memo that goes to the investment committee answers four questions: why this business, why now, why us, and what could go wrong.

A thesis framework

1. Market — size, growth, cyclicality, competitive dynamics.
2. Business quality — recurring revenue, customer retention, pricing power, margins, cash conversion.
3. Value creation plan — the specific levers: organic growth, pricing, cost programme, add-on acquisitions, working capital, professionalising management.
4. Returns — base, upside and downside cases, with the deal still clearing a minimum return in the downside.
5. Key risks and mitigants — customer concentration, technology disruption, leverage, key-person risk.
6. Exit — who buys it in five years, and at what multiple.

A strong interview answer is specific: "Three reasons: 85% recurring revenue with 95% gross retention, a fragmented market where we can buy add-ons at 6–7x versus our 11x entry, and a pricing gap versus the market leader."

Quality of earnings (QoE)

A QoE report, usually by an accounting firm, tests whether reported EBITDA is real, recurring and cash-backed. Because the purchase price is a multiple of adjusted EBITDA, every adjustment is worth that multiple in value.

Worked example

Management presents EBITDA of 50. Diligence finds:

• A one-off gain on an asset sale of 5 included in EBITDA → remove, −5
• A genuine one-time litigation cost of 3 → add back, +3
• The founder is paid 1 but a market-rate CEO costs 3 → normalise, −2

Diligence-adjusted EBITDA = 50 − 5 + 3 − 2 = 46. At 10.0x, that is 40 less value than the headline number — enough to change the bid.

QoE also looks at revenue recognition, normalised working capital (to set the working capital peg in the purchase agreement), capex needs and customer concentration.

Other diligence workstreams

Red flags interviewers expect you to spot

• Revenue growth driven by one customer or aggressive recognition.
• Rising receivables or inventory relative to revenue (earnings not converting to cash).
• Large, repeated "one-off" adjustments.
• Capex below depreciation for years (underinvestment).

Why buy a company in a "risky" industry?

Sponsors buy technology and other volatile sectors when revenue is recurring (subscriptions), switching costs are high, and growth offsets lower leverage. They adapt the structure — less debt, more equity, sometimes growth or minority deals.

Interview answer template

"I'd underwrite the thesis on market, business quality, a specific value creation plan and the downside case, then test it in diligence — commercial work on the market and a QoE on EBITDA, since every dollar of EBITDA is worth the purchase multiple."