by Brian DeChesare Comments (2)

How to Start a Private Equity Firm – and Why You Probably Shouldn’t

How to Start a Private Equity Firm

If you search for “how to start a private equity firm” online, you’ll find results that range from useless to tangentially useful to occasional nuggets of real wisdom.

That said, much of it is better than the junk found on generic websites about how to start a hedge fund.

But the main problem remains the same: most sources discuss the process without mentioning the prerequisites.

Starting a private equity firm is a bad decision for ~95% of people who work in the finance industry.

It’s also not something you can do until you’ve reached the top of the ladder in private equity (or very close to it).

Oh, and it worked much better in 1990, 2000, or even 2010 than in the 2020s and beyond.

Since I enjoy destroying your hopes and dreams, let’s get started with the full break-down:

What is Private Equity? How Does It Work?

In this article, I will assume that you know what private equity is, what the career path is like, how PE recruiting works, and how compensation and carried interest work.

We have detailed articles on all these topics (click the links), so I don’t want to waste time re-explaining them.

How to Start a Private Equity Firm: People, Experience, and Capital

The most common backgrounds for starting a private equity firm include:

  • VPs or Principals at existing upper-middle-market (UMM) or mega-fund (MF) firms who are good at their jobs but disenchanted with the fund economics or promotion opportunities.
  • Partners and MDs who have better economics but may not like other aspects of the firm, such as the Founders or senior Partners, the office politics, the industry focus or investment strategy, the LP relationships, etc.
  • C-level executives in normal industries who have done deals before, have extensive investor relationships, and now want to branch out and move into PE (far less common).
  • MD-level bankers who might have some investing experience (e.g., through merchant banking or angel investing) and now want to do it full-time (also far less common).

The bottom line is that it’s probably a minimum of 10 years of full-time work experience before you can even consider starting your own PE firm.

I doubt that anyone could do it successfully below the age of 35 today, and most founders are probably in their 40s or beyond.

Assuming you have substantial PE work experience, here are some additional requirements:

  • A great track record of deals in which you made the final investment decision and led the company in some way. And you need credible evidence showing that you were personally responsible for the results (difficult since PE is more of a “team sport”).
  • Solid Limited Partner (LP) relationships at endowments, pensions, funds of funds, family offices, sovereign wealth funds, etc., so you can raise the required capital. A network of dozens of ultra-high-net-worth (UHNW) investors worth $20 – $30 million each might also work.
  • A proven strategy in a specific, differentiated niche. If your investment thesis is “undervalued industrial companies with between $5 and $15 million in EBITDA,” try again.
  • The ability to contribute several million dollars of your own capital while you’re fundraising, paying for legal/other expenses, and operating the fund in the first few years. If you’re uncomfortable writing a check for $1 million, you have no business starting a PE firm.
  • Talent at investing, execution, AND sales. It’s hard enough to be great at even one of these, let alone all three. But each skill will be essential as you raise a fund, hire people, and do deals.

Degrees such as an MBA or a Ph.D. mean absolutely nothing, and certifications like the CFA and anything else with a “C” in front are useless in this world.

But let’s stay positive and assume you’ve met all these prerequisites.

In that case, the first step of the process will be raising capital:

How to Start a Private Equity Firm, Part 1: Raising Capital

This step is similar to the fundraising description in the article about how to start a hedge fund:

  • You still need a specific, repeatable, and understandable investment strategy.
  • And you’ll still market your new fund to funds of funds, endowments, pensions, family offices, and high-net-worth individuals.

Also, as with hedge fund fundraising, you’ll get faster results by targeting family offices and HNW individuals rather than huge, bureaucratic endowments or pensions.

You need robust marketing materials that present your team’s background, all the deals you’ve worked on together, and explanations of ones that performed well and ones that did not.

No PE firm earns a 20-30% IRR on every single deal, so you need to address ones that underperformed and how they influenced your process and future results.

Other important points for the marketing materials include:

  • Team: Ideally, you want at least 2 GPs (other Partners), so you have a team of 3 when starting your firm. Your materials must demonstrate how you’ve worked together over a long period (ideally 5-10 years) and gotten consistent results in a specific niche.
  • Sourcing: Where will your deal flow come from? How will you have an advantage over all the other firms also seeking solid companies to invest in? Of course, relationships with bankers and brokers help, but what edge do you have over other PE firms that also look at banker-led auctions?
  • Runway / Personal Contributions: How much money is your team contributing to operate the firm while this fundraising process is taking place? If this number is anything less than “the low millions,” you should reconsider your plans.

As with all fundraising, the entire process is incredibly time-intensive and ego-bruising.

To give specific numbers, if you conduct 20 meetings with potential investors, you’ll be lucky to find one who ends up investing (5% success rate) – and it could be much worse than that.

The biggest differences vs. the HF fundraising process relate to the fund size and the minimum investment amount.

If you’re starting a hedge fund, you don’t need to strictly define your “size” because you can keep the fund open-ended and start investing with smaller amounts of capital.

But it’s much harder to do this in private equity because you’ll have a set number of portfolio companies, each one will be worth a certain amount, and they’ll require a specific headcount to support.

EXAMPLE: Let’s say you’re planning to have 10 portfolio companies in your first fund, and the average Purchase Enterprise Value will be $50 million. At an average 10x EBITDA multiple, each company will have ~$5 million in EBITDA, putting you in “small / lower-middle-market” territory.

Each deal will use an average of 50% debt, which means you need to raise capital of $50 million * (1 – 50%) * 10 = $250 million to acquire these 10 portfolio companies.

For a fund of this size, you’ll need a minimum investment amount of at least several million dollars unless you want to spend ages collecting $200K checks from random wealthy people.

That already limits your investor base and means it will take longer to complete the fundraising process.

But you also need to consider the management fees and what kind of headcount they can support.

In this example, if you charge a 2% management fee, that’s $5 million per year.

That seems like a lot, but if you count all the overhead expenses such as office space, accounting/legal, HR, IT, compliance, administration/marketing, etc., the remainder might cover only:

  • 3 Partners (your founding team).
  • Maybe ~2 VPs or Principals.
  • And maybe ~2-3 Associates.

And everyone would earn below-market compensation (e.g., maybe 50-70% of the cash compensation at a larger fund).

If $5 million per year won’t cover everything you need, the usual answer is “take a pay cut until you grow and raise a larger fund.”

I’ll close this section with some good news about fundraising: the first 50% is much harder than the last 50%.

“Anchor investors” are crucial for kickstarting the process and convincing other investors that you’re serious, so you may need to offer them better terms in exchange for their early commitments.

For example, you might offer lower performance fees, a higher split of the profits, or a higher hurdle rate to incentivize them.

If you can raise enough from these early LPs, you might even be able to do a few deals before your fund closes and use these “seed assets” to keep marketing the fund.

If you cannot raise close to the amount of capital your fund will need, your best options are to raise money deal-by-deal to prove yourself until you can raise an entire fund or to go the search fund route.

How to Start a Private Equity Firm, Part 2: Paperwork and Legal Structure

In the U.S. and Europe, most private equity funds are established as Limited Partnerships or Limited Liability Firms, and you’ll need competent attorneys to complete all the necessary paperwork and registration documents.

Among the documents you’ll have to complete are the Limited Partnership Agreement (LPA), Articles of Association, Offering Memorandum for marketing the fund, Subscription Agreement, Investment Management Agreement, Due Diligence Questionnaire, Compliance and Risk Guidelines, Custody Agreements, Counterparty Risk Agreements, Valuation Policy, and more.

Some of the key terms spelled out in these agreements include:

  • Fees: Will you charge a 2% management fee? 1%? 1.5%? What about the performance fee? 20%? 25? 15? Will you raise one of these fees for a lower percentage on the other fee?
  • Hurdle Rate: What IRR does your firm need to earn before the GPs (your founding team) earn a percentage of the profits?
  • Investment Targets and Restrictions: What types of companies will you invest in? Are you restricted from certain types of deals, industries, or strategies?
  • Distributions: How frequently will you distribute dividends, cash flows, interest, and realized gains to your LPs? How will Preferred Returns, Catch-Up Returns, and Claw-backs work in the context of this returns waterfall?
  • Term and Transfers: How many years will this fund last, and what options do the LPs have if they want to exit early? For example, can they sell their stakes to other LPs in the secondary market?
  • Co-Investments: If the LPs like one deal, can they contribute extra capital to fund that specific deal and earn a higher percentage of its profits?

These agreements are long and complicated, and the legal fees alone will probably end up costing you over $1 million.

If you want real-world examples and templates, check out the ILPA’s collection of term sheets.

How to Start a Private Equity Firm, Part 3: Hiring a Team

Your initial “team” will be the 1-2 other Partners with whom you start the fund.

You probably won’t be able to do this solo or with just one Partner because the “key person risk” will be too high.

Even if you can raise $200 – $300 million for your first fund, it’s not enough to support a huge team because the management fees are only $4 – $6 million at that level, and other expenses will eat up a good chunk of them.

You’re also at a disadvantage because you cannot possibly offer the same salaries and bonuses to new hires that Blackstone or KKR can.

You can sometimes offset that by offering them higher carried interest or the ability to co-invest in deals, but you’re unlikely to attract the “top” bankers or PE professionals to a brand-new fund.

So, you may have to focus on “non-traditional candidates” who can get anything done, no matter how random or ridiculous the task is.

You don’t want people from Oxford or Harvard with perfect grades; you want diamond-in-the-rough candidates who had to network like crazy to get into the industry and succeed.

If you perform well enough to raise a larger fund eventually, your investment and non-investment staff will grow because the legal/compliance/auditing/other tasks will also keep growing.

But, on balance, growth almost always means higher compensation for everyone because the headcount won’t scale linearly with your assets under management.

As you move into the $1 billion+ range, you can start recruiting more like traditional, established funds that go through headhunters and might even participate in on-cycle recruiting.

How to Start a Private Equity Firm, Part 4: Surviving, Investing, and Growing

Although raising the capital for your first fund and hiring the initial team are both extremely difficult, the rest of the journey isn’t exactly a walk in the park.

The biggest issue is that many founders do not realize that they are not just “investing” or “executing deals” but also running an entire business.

That means that as you’re hunting for deals, you’re also:

  • Being hyper-responsive to your LPs, especially the anchor investors who helped you get started.
  • Solving HR issues, whether it’s someone complaining about their compensation, a co-worker, or your ESG policies.
  • Fixing portfolio company problems, whether they relate to disappointing earnings, growth initiatives gone awry, employee protests, problems with labor unions, or anything else.
  • Dealing with legal problems, such as LPs who are angry about one part of their agreement or portfolio companies getting sued.
  • Representing your firm to the outside world, speaking with media outlets, and attending conferences.

It may be better than investment banking hours, but you’ll still have almost no personal life in the early stages of your fund.

And it’s much tougher than being a VP or Principal at an existing fund because you’re responsible for far more of these random tasks.

If you want to grow and eventually raise another fund, you need solid evidence of successful exits and positive cash-on-cash multiples.

“Unrealized gains” are not taken seriously by credible LPs, so no matter how much progress your portfolio companies make, it means little until you’ve sold them for good multiples.

Depending on your strategy and targeted companies, this might take years.

For example, you might think it’s “easier” to acquire lower-middle-market companies worth around $50 million.

But in this size range, it is very difficult to find companies that can grow substantially or expand into new markets.

And even if you do find growth opportunities, it will take longer to execute them for companies of this size.

As you grow, you’ll need to start moving up-market and targeting larger companies.

How to Start a Private Equity Firm, Part 5: Exit Opportunities

Let’s start with the bad news: if your PE firm does not work out, you’re unlikely to get a “second chance.”

It’s not like tech startups where failure is seen as routine; even if you wait 10-15 years, service providers, lawyers, and LPs will still remember your first failure.

Beyond that, your exit options depend on why your firm failed.

If it was due to performance, you’re probably not going to get another job in private equity, but you might be able to join a normal company in a deal-making role or even move back into investment banking or a related finance role.

If it was due to issues with your team or not being able to raise enough capital for another fund, you could potentially join an existing PE firm.

You could also move further down-market and start a search fund or raise capital for individual deals if your performance was good, but other factors were not.

So, Why Is It Such a Bad Idea to Start a Private Equity Firm?

If you’ve read this far, the downsides should already be obvious:

  • Raising enough capital is extremely difficult, and a startup PE firm requires more capital than a startup hedge fund.
  • There are no second chances if you fail.
  • It’s stressful and time-consuming, and you’ll almost certainly take a pay cut when starting out.
  • It’s more difficult to “prove” your results, and you need significant credentials and on-paper qualifications.

But there’s a more fundamental problem as well: by the time you’re in a good position to start a private equity firm, it usually makes more sense to stay at your current firm.

MDs and Partners have the best LP relationships and are, therefore, the best positioned to raise capital for a new fund…

…but they also already earn millions of dollars per year (or more), so they have little reason to leave.

Yes, they could get a higher percentage of the carried interest at their own firm, but their own firm would also be smaller – at least in its first 5-10 years.

And a smaller firm means lower management fees and investment profits, which translates into compensation that may not necessarily be higher for many years.

Would an MD or Partner in their early 40s want to go through everything above to start their own, smaller firm to potentially earn closer to $10 million per year – if the fund performs very well – rather than the low millions per year?

And is the reputation/financial risk worth it if the firm fails or delivers only mediocre performance?

To me, the answers are clearly “no,” but some people do think it is worth the risk, money, and effort.

Another major downside is that private equity is a much more saturated market today than in previous decades.

There’s too much capital chasing too few high-quality companies, which means that returns will almost certainly decrease in the future.

Finally, the macro environment is now quite unfavorable.

If you think about the 1980 – 2020 period, almost everything benefited private equity: falling interest rates, low inflation, good demographics, rising emerging markets, plentiful energy, and a massive bull market in risk assets.

We’re no longer in an environment of “falling interest rates,” “low inflation,” or “plentiful energy,” and the other factors are all worse as well.

Some firms will still succeed, but it will be difficult to do so simply by riding the macro wave.

Alternatives to Starting a Private Equity Firm

If you want to start a private equity firm, there’s a ~95% chance you probably shouldn’t.

But the alternative options depend on your goals.

Let’s go through the list:

  • If you want prestige and the ability to tell people that you “run a PE firm,” you should seek a psychiatrist or therapist.
  • If you like PE and want to earn more or get promoted more quickly, move to a different firm or group.
  • If your goal is to “become wealthy,” i.e., $5 – $10 million net worth but not necessarily a $100+ million net worth, start your own business, invest in real estate, or join a startup. Or stay in the finance industry and grind your way up.
  • If you still want to start your firm but have little experience/money and cannot raise much capital, think about search funds.
  • If you inherited an 8-figure sum from your uncle and want to “play around with it,” think about starting a micro-VC firm or making angel investments. This is enough money for investing in early-stage companies but not for private equity.

And if you’re a university student, my advice is to avoid thinking about any of this because you have no idea what the world will be like in 10-15 years.

Get experience in different industries, complete internships early in university, and, most importantly, develop marketable skills in your 20s that will make money in any environment.

Do that, and you’ll probably forget that you ever looked up how to start a private equity firm.

About the Author

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys memorizing obscure Excel functions, editing resumes, obsessing over TV shows, traveling like a drug dealer, and defeating Sauron.

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  1. Do you have specific examples of the best marketable skills to develop in your 20s?

    1. Sales and marketing are the best. Learn how to sell on the phone, face-to-face, and in writing (email, online, etc.) because most people cannot even do one of those well. Doing all 3 well will give you a huge advantage. Also, learn how to build a brand for yourself and become known for something specific so that you don’t even have to sell – you want people to come to you for needs X, Y, and Z.

      Basically, focus on everything that professors and students at “elite universities” ignore but which are essential to career success. For more suggestions, see this book:

      https://www.amazon.com/Education-of-Millionaires-audiobook/dp/B0073J4FRA

      There are also technical skills like programming, Excel/VBA/SQL, etc., but these are easier to learn independently outside of actual work experience.

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