Class 04: With Other People’s Money

Who invests in private equity, and why?

A limited partner (LP) puts money into a fund. The LP supplies capital, while the general partner (GP) runs the fund under its agreement.

Carry is a share of investment profits. This carried interest is usually paid to the GP.

Management fees pay the management company for managing the fund. Distributions are money the fund pays to its investors.

The Daebak Capital entity map below separates the fund, its GP and its management company. Gross results show what the investments earned before fund fees and carry.

Net results show what is left after those charges.

An investor’s cash needs and investment rules shape which funds it can back.

• Pension funds (California Public Employees’ Retirement System and Ontario Teachers’ Pension Plan) invest to meet benefit payments due today and in future years.
• Insurers (Allianz, AXA and MetLife) invest with future claims and other bills in mind.
• Endowments (Yale, Harvard and Stanford) help pay an institution’s costs now and in future years.
• Sovereign funds (Abu Dhabi Investment Authority, GIC and Korea Investment Corporation) invest public money under the rules set for them.
• Family offices (Cascade Investment, Walton Enterprises and DFO Management) invest to meet a family’s goals and needs.
• Funds of funds (HarbourVest, Hamilton Lane and StepStone) invest in other funds rather than selecting operating businesses directly.

A fund of funds sits on both sides of the table. It manages money for its own investors, then acts as an LP when it puts that money into other funds.

How do managers find investors and win commitments?

Managers need to reach investors whose rules fit the fund, show that their team can deliver, and secure a signed commitment. A good meeting starts that work; it does not finish it.

In the simulation, GP teams raised money and LP teams chose whom to back.

We began with two questions from Class 3. Does this fund fit the LP investor’s mandate, and is this GP manager worth backing?

A mandate says what an investor is allowed to buy. Underwriting means checking whether the investment is worth making.

A meeting is one stage in a longer decision

These terms tell you where the conversation stands. They are not steps that every investor must take.

• No meeting: you have not gained access to the investor.
• Pass: the investor declines.
• Diligence: the investor needs more evidence.
• Soft circle: the investor expresses interest without making a binding promise.
• Commitment: the investor promises to provide money under a signed agreement.
• Capital call: the fund requests payment under that commitment.

Search takes time, and so does deciding when to stop

I used the secretary problem as a comparison. In this optimal stopping problem, you see candidates one at a time and must accept or reject each on the spot.

How long do you keep looking, and when do you decide? Fundraising lets you return to people and negotiate, so the secretary problem offers a useful question without giving us a rule to follow.

Time spent raising money is time you cannot spend running the investments you already have.

Where do fund managers find investors?

• Start with people who have seen you work.

  Former bosses, former partners, colleagues and anyone you have made money for. That last group matters most, because they can say the one thing that counts: “I watched this person produce.”

  Some of these people will invest. Others will not, but they will vouch for you to someone who might.

  A vouch from the right person is often worth more than the check.

  Be specific about whom you want to meet and why.

  “Do you know anyone who might be interested?” hands the other person a job. “I want to meet the chief financial officer (CFO) who ran the roll-up at Company X, because I am about to do the same thing in Korea” is a favor someone can deliver in 30 seconds.

  One of your classmates taught me the German term for this: Vitamin B. B for Beziehungen, which means relationships.

  It is the one nutrient that hard work alone will not produce. You have to go get it.

• Your past investors: If you’ve run a fund before, they re-up or they don’t. Stay in touch between funds so the ask isn’t a surprise.

• Cold outreach: Write to an investor without an introduction. Say why your fund fits them and what you’re asking for.

  Works better when you can name who’s already in.

• Emerging-manager programs: Some large pensions have a formal application for new managers. Read the rules and follow them.
• Conferences: Useful only if the investors you want are in the room.

• Research databases: Show you who backs funds like yours. A name on a list is not a lead.

• Placement agents: You pay them, usually a cut of what they raise, to find investors. The good ones are picky about whom they take on.

• Investment consultants: They advise investors on which managers to pick. They work for the investor, not you, but you can send them your materials.
• Wealth platforms: Put your fund in front of financial advisers who invest for wealthy families.

Every one of these ends in the same question from the investor: why you, and why now?

What does a placement agent add?

A placement agent can help a manager meet investors who fit the fund. The agent can explain what those investors want and help persuade them to commit.

I entered the game as a placement agent.

I knew every team’s preferences, which gave me a wider view than any single manager had. This gap is called information asymmetry.

The game offer was a 5% fee on money raised through my introductions, payable only if an introduction produced funding. In this exercise, the management company bears the agent’s fee.

The worked fee example below shows where that payment comes from.

I chose 5% to add drama to the game. In practice, fees vary with the fundraise and the services agreed.

An agent may charge for its time as well as for raising money. The agreement sets this retainer, who bears each cost, which commitments earn a fee and when payment is due.

It also sets any fees on later commitments or new funds.

What the agent could change

I arranged meetings for my clients before opening the round to other teams. I also asked investors what worried them and what facts might persuade them to invest more.

One investor liked a manager’s pitch but worried about its lack of fund-management experience. As the agent, I suggested to that investor that an experienced operating team could help address the concern.

I offered to share more about those people later.

Another investor asked the manager to put in more of its own money. How much risk would the manager share?

Note: Running a company and running a fund call for different skills. Ask whether the team can choose a group of investments, run the fund’s accounts and report clearly to investors.

What students thought they were buying

After the game, you named 2 reasons to hire the agent: knowing who was interested and getting a meeting.

Another reason came up too: one team feared falling behind teams that hired the agent. Using other people’s choices or approval to build trust is called social proof.

A student said the agent helped tip a close decision. Did the agent bring a useful fact, or did hearing a confident recommendation make the investor feel better?

I argued that a good intermediary brings expertise and market knowledge worth paying for. Check their work and their relationships before you hire them.

The fee can hurt. Missing a good opportunity because you lacked the right help can cost more.

Managers’ expectations and investors’ allocations

I asked investor teams to write down which managers they intended to fund and how much. I separately asked manager teams to record how much they expected to raise and from whom.

Did both sides hear the same conversation? Compare the lists, then ask the investor to confirm the amount.

Where does the committed money go?

Investors pay money into the fund when called. The fund uses part for fees and puts the rest into businesses.

The entities have different jobs

Daebak Capital is the investment firm. Daebak Capital Management Co. is its management company, which hires the team and collects management fees.

Daebak Equity I, called Fund I below, is the fund, with its own investors, investments and accounts. Daebak Equity I GP is its general partner.

It is the firm’s first fund; Class 3’s Daebak Equity III is its third. Fund I uses the assumptions below.

The fund has an agreement that sets its rules. This is the limited partnership agreement (LPA).

The fund can own a business through a holding company (HoldCo), a company set up to hold the investment. A business a fund owns, such as Sunrise Bunsik in Daebak Equity III, is a portfolio company.

A lender makes its loan to the borrower named in the deal. That loan is separate from an investor’s promise to put money into the fund.

Follow 3 paths for the money:

1. Investors put money into the fund.
2. The fund pays fees to the management company.
3. Money from investments flows back through the fund to investors and those entitled to carry.

Assumptions for the worked example

• Commitments: $100 million total, $98 million from outside LPs and $2 million from the GP.
• Calls: the fund asks for the full $100 million over time, and each investor pays its share.
• Management fees: 2% of the original commitment a year in years 1–5, then 1% a year in years 6–10. The base stays at $100 million.
• Investments: the fund budgets for all 10 years of fees before deciding how much it can invest. Any extra money put into an existing investment must fit within that budget.
• Carry: 20% of total profit after returning the full $100 million contributed. No preferred return or catch-up in this base case.
• GP capital: in this example, the GP’s $2 million shares fund costs and receives 2% of the amount left for capital investors after carry. Daebak Equity I GP receives carry separately; actual agreements may treat GP capital differently.
• Left out: fund borrowing, recycling (reinvesting early proceeds), taxes, other fund expenses. Every investment is sold by the end of year 10.

These fees are teaching assumptions. Actual funds use different rates and bases, often changing the fee base after the investment period.

From soft circle to cash received

Suppose an outside investor soft circles $20 million. It has expressed interest without making a binding promise.

Once it signs a commitment, it must pay when the fund makes calls under that agreement.

If the fund calls 20% of commitments in year 1 and 15% in year 2, this investor pays $4 million and then $3 million. It has paid in $7 million and has $13 million uncalled.

The investor needs a plan for future calls, even if money from other investments comes back late. The uncalled amount is still a promise to pay; it has yet to reach the fund.

Here, fees apply to the full amount promised, even before the fund asks for all the cash. Calling less capital does not reduce the fee.

The agreement says how much notice the fund must give before a payment is due. Read what happens if you miss that payment before you sign.

Fees determine how much reaches businesses

Years 1–5 cost $2 million a year, or $10 million. Years 6–10 cost $1 million a year, another $5 million.

The fund budgets $15 million of commitments for fees and $85 million for investments.

Class 3’s exercise uses the same terms: $15 million of fees over ten years, leaving $85 million to invest.

This is a plan for using the promised money over 10 years. Cash arrives as investors pay calls for investments and fees; we have not set every payment date.

In the prepared placement-agent example, the agent introduces $60 million of commitments at 2% and earns $1.2 million. Daebak Capital’s management company pays that from its $15 million of fee revenue, leaving $13.8 million before its other operating costs.

The prepared example uses 2%; my classroom offer used 5%. These are two different fee assumptions.

The fund does not deduct the $1.2 million again from its $85 million budget. The agent is paid out of fees already counted.

We leave the agent’s payment date open. If it falls due before enough management fees arrive, the management company needs cash of its own to cover the gap.

How do investments produce returns?

The fund gets cash when businesses pay it or investments are sold. The return depends on how much it invested and what comes back.

10 investments produce different outcomes

The fund invests $8.5 million of equity in each of 10 deals, including any follow-on capital. That money can buy shares from existing owners, provide new capital to the business, or do both; this model does not split those uses.

Use the slide’s multiples for the sold investments: 0.2×, 0.5×, 0.8×, 1.0×, 1.5×, 2.0×, 2.5×, 3.0×, 4.1× and 5.2×. They sum to 20.8, so the average is 2.08× and proceeds are 20.8 × $8.5m = $176.8m.

4 investments return their cost or less. The 2 best contribute $79.05 million of the $176.8 million total, showing how strongly proceeds depend on those winners.

The simple average works because we put the same amount into each company. If the amounts differ, add up all the money returned and divide by all the money invested.

A multiple is different from a percentage gain

Suppose an investment starts with $100 and ends with $125 after 5 years, with no payments in between. Its multiple on invested capital (MOIC) is 1.25×, and its total gain over those 5 years is 25%.

The multiple includes your original money. The percentage gain measures how much you earned above it.

The yearly return is about 4.56%: (125 ÷ 100)^(1 ÷ 5) − 1. If someone mistakes the 25% total gain for a yearly internal rate of return (IRR), they would expect $100 to grow to about $305 over 5 years, rather than $125.

Say which return you mean and how long it took. Give the person listening a fair chance to follow your reasoning.

Debt can increase gains and losses

In the strong Sunrise Bunsik example, borrowing lets owners put in less money and earn a higher return on it.

Borrowing can also make the loss bigger. Interest still comes due, and lenders must be repaid even when the sale price disappoints.

At the slide’s all-debt extreme, a $5.6 million loan pays for the $4.2 million purchase and $1.4 million expansion, so owners put in no money. Borrowing only the purchase price would still require $1.4 million of equity for expansion.

With zero equity paid in, you cannot calculate the multiple by dividing by zero. You would also need a lender willing to fund the whole amount.

Required interest and principal payments must be met before cash is paid to equity owners. Owners may receive cash while debt remains if the loan terms allow it.

Check the interest burden

Suppose a business earns $5 million before interest, taxes, depreciation and amortization, and borrows $20 million at 10% annual interest. Against that EBITDA, the yearly interest bill is $2 million.

EBITDA is a profit measure that leaves out the costs named above. It covers that interest bill 2.5 times: $5m ÷ $2m = 2.5×.

Subtracting the interest leaves $3 million, with other bills still to pay. Taxes, equipment, day-to-day cash needs and loan repayments can use it up.

Who gets paid when investments are sold?

The fund follows its agreed payment rules. In our example, capital comes back first, then profits are split between capital investors and the GP.

From investment proceeds to investor proceeds

First pay back the $100 million investors put in, including the part spent on fees. This money comes from selling investments; the management company keeps the fees it earned.

Profit is $176.8m − $100m = $76.8m.

The general rule here is Carry = 20% × max(0, proceeds − contributed capital). In this case, carry is 20% × $76.8m = $15.36m.

Those who put in capital receive the remaining $161.44 million. That includes their original money.

Outside LPs receive 98% of $161.44 million, or $158.2112 million, on their $98 million. Their exact net multiple is 1.6144×, or approximately 1.61×.

That includes the original money: the total gain is (1.6144 − 1) × 100 = 61.44%. That gain covers the full investment period.

Keep these 3 income streams separate: the GP receives $3.2288 million as a capital investor and $15.36 million as carry recipient. The management company receives $15 million in fees and pays its own costs from that revenue.

The pieces add up: $158.2112m + $3.2288m + $15.36m = $176.8m. Do not add the $15 million of fees to investor distributions; that money already left the fund.

If sales brought in only $80 million, the fund would pay no carry and return 0.80× to those who put in money. The manager would still have collected its management fees.

A preferred return and catch-up change the order of payments

A waterfall sets who gets paid first and how the money is split. This separate waterfall example has $250 million to pay out.

Investors put in $100 million. The agreement gives them a $40 million preferred return, then a full GP catch-up, followed by an 80/20 split.

Leave out the GP capital contribution and fees in this separate preferred-return example.

Investors have the first claim on profit under these terms. That claim is the preferred return.

The fund still needs enough money to pay it. A catch-up then pays the GP until it has caught up to its agreed share of profit.

1. Investors receive $100 million of capital and $40 million of preferred return.
2. The GP receives $10 million of catch-up. Of the $50 million in profit paid so far, the GP has received 20%.
3. The remaining $100 million splits $80 million to investors and $20 million to the GP.

Why does the GP receive $10 million rather than $8 million? Its catch-up is part of the total profit shared so far.

Investors have received $40 million of profit. For that to be 80% of the profit paid so far, total profit paid must be $50 million: $40m ÷ 80% = $50m.

The GP receives the other $10 million: $50m − $40m = $10m. That gives it 20% of the $50 million.

Call the catch-up x: x ÷ (40 + x) = 20%. This gives x = 8 + 0.2x, then 0.8x = 8, so x = $10 million.

Investors receive $220 million in total. The GP receives $30 million of carry, equal to 20% of the $150 million profit.

Without a preference, the same 20% profit share would also produce $30 million of carry at these proceeds.

At $130 million of proceeds, the same $40 million preference leaves investors with all $130 million and the GP with zero carry. Without the preference, 20% of the $30 million profit would give the GP $6 million and investors $124 million.

We have assumed that the preferred return due is $40 million. To work it out in a real fund, you need its rate, dates and rules for compounding.

Whole-fund and deal-by-deal waterfalls

Under a whole-fund waterfall, the GP waits. Investors first get their capital back across the fund, plus any preferred return due.

Under a deal-by-deal waterfall, the GP may earn carry when one deal is sold. If later deals lose money, it may have to pay some carry back.

Whole-fund rules are often called European, and deal-by-deal rules American. Either structure can be used outside its named region.

Each agreement sets the rules for holding back or repaying carry. The Institutional Limited Partners Association’s overview also covers mixed structures.

Separate example, excluding fees and preferred return: a fund makes 2 investments of $50 million each. Deal A sells in year 4 for $80 million, a $30 million profit.

Deal B sells in year 8 for $20 million, a $30 million loss.

Assume the rules let the GP take carry without setting money aside for a loss on Deal B. In year 4, it takes 20% of Deal A’s profit, or $6 million.

Across the whole fund, total profit is zero, so the GP has earned no carry.

Investors receive $74 million from Deal A and $20 million from Deal B, totaling $94 million before clawback. Once the GP pays back the $6 million, investors have their full $100 million.

That $6 million is excess carry, which the GP must repay. This clawback returns the missing money to investors; under whole-fund terms, they receive $80 million and $20 million before the GP earns carry.

How much comes back, and how long does it take?

Track both the money returned and the time it took. A multiple shows the amount; IRR also uses the dates.

Separate cash received from value still held

Separate example: you put in $5 million and got $2 million back. What you still own is valued at $6 million, but you have not received that amount in cash.

• Distributions to paid-in capital (DPI): $2m ÷ $5m = 0.40×.
• Residual value to paid-in capital (RVPI), the value still held divided by money paid in: $6m ÷ $5m = 1.20×.
• Total value to paid-in capital (TVPI): ($2m + $6m) ÷ $5m = 1.60×.

These figures all belong to the same investor, use the same date and allow for fees and carry. On that basis, TVPI equals DPI plus RVPI.

In our Daebak Capital case, every investment has been sold and all money paid out. Nothing remains to value, so the outside investors’ final DPI and TVPI both equal 1.6144×.

A multiple does not tell you the dates

A multiple tells you how much money comes back for each dollar invested. Internal rate of return (IRR) also uses the dates of each payment.

At first, you have paid more into the fund than you have received. A higher estimate of what you own cannot pay your next capital call.

A performance J-curve may show returns or values rather than cash. Read the axis label before drawing a conclusion.

A subscription line changes timing and adds a cost

A fund can borrow against investor commitments before calling their money. This loan is a subscription line.

An acquisition loan pays for buying a business and relies on that business to repay it. The two loans sit at different levels: the fund and the deal.

Separate example, no borrowing: the LP pays $100 at year 0, the fund invests it, and the LP receives $200 at year 5. The multiple is 2.00× and IRR is 14.87%.

Borrowing without cost: the fund borrows and invests $100 at year 0, then calls $100 from the LP at year 1 to pay back the original loan. The LP receives $200 at year 5, producing 2.00× and an 18.92% IRR over 4 years.

The investment brings back the same amount in both cases. Paying later shortens the LP’s return clock.

Borrowing with cost: keep that same timeline, but take the assumed $10 loan cost out of the $200 received at the sale in year 5. The LP receives $190, producing 1.90× and a 17.41% IRR over 4 years.

Ask what the loan costs, when money moves and how returns compare with and without the loan.

What makes investors back the next fund?

Investors need reasons to trust the team again and enough cash to commit. Past results, cash returned and the next fund’s plan all matter.

Fundraising is a repeated game

Fund II starts in 2017, 3 years after Fund I, before Fund I’s 10-year outcome is known. The LP has to decide with what it knows in 2017.

Money returned by Fund I could help an investor back Fund II, but our example does not say how much arrived by 2017. Investors need a plan for paying calls, even if they choose not to keep every uncalled dollar in cash.

You may like the manager and still lack the money to invest again because earlier investments have not sold. Would you commit, and what fact would change your mind?

Larger funds change the firm’s fee income

Daebak Capital raises a larger fund every 3 years. Each fund lasts 10 years, and its fee rate falls by half after year 5.

The fee is still based on the amount investors first promised.

The start year counts as year 1. Fund II therefore starts in 2017 and reaches year 10 in 2026.

For Fund IV, lifetime fees are 5 × $17.5m + 5 × $8.75m = $131.25m. A smaller fee rate can still bring in more money when the fund grows enough.

Several funds pay the firm at once

In 2026, Fund II is in year 10 and pays $2 million. Fund III is in year 7 and pays $4 million.

Fund IV pays $17.5 million and the new Fund V pays $30 million.

Together they produce $53.5 million of fee revenue in 2026, the peak within this 5-fund schedule. Fund I has already ended, and the firm still pays staff, the costs of meeting rules and other bills.

The $461.25 million total covers all 5 funds from 2014 through 2035. It assumes every fund is raised and runs its full 10 years, and it is revenue before costs.

Growth creates another underwriting question

A larger fund earns Daebak Capital more fees, but may need bigger deals, new sources of investments and more people. Can the team grow without losing its discipline?

What protects investors when things go wrong?

Check the agreement before you invest. What happens if a leader leaves, a conflict arises or the GP receives too much carry?

Check what can be done, who must vote and how many votes are needed. Look for any exceptions too.

• If a named leader leaves or gives too little time, the agreement may pause new investments. This is a key-person provision.

  Investors then decide what to do under the agreement’s rules.

• Investors may be able to replace the GP after a serious breach. These removal rights can also apply without a breach if the agreement allows it.

• The manager may face a conflict, such as a sale between 2 of its funds. A limited partner advisory committee (LPAC) can review matters assigned to it under the agreement.

  Daily investment choices stay with the manager.

• An investor may agree on extra terms with the fund. A side letter records those terms.

• Other investors may be allowed to choose some of those terms. These most-favored-nation (MFN) rights apply only to covered terms and investors who qualify.

The Institutional Limited Partners Association (ILPA) Principles suggest ways to oversee funds and keep managers’ interests in line with investors’ interests.

Your rights come from the fund documents and the law that applies.

Clawback collection and fee refunds

For the carry clawback, check who must repay the money and whether they can pay. Management fees stay in place after poor results unless separate terms or a legal basis allow a refund.

What responsibility comes with owning a business?

I asked you to stand along a scale from 1 to 5 based on your view of private equity. You could not choose the neutral middle.

Each group explained its position. Then we asked what evidence or experience might change your mind.

Separate an ownership structure from its consequences

You asked about how long owners keep a business, its debt, jobs, prices and what customers receive. One student described smaller restaurant portions, and I asked whether the cause was ownership, growth in scale or another operating decision.

We did not settle the cause. The exchange turned an experience into a question you can investigate: who decided what, and why?

Students defending private equity pointed to new investment and better-run businesses. I asked what made the case for this way of owning and funding a business, beyond the general case for capitalism.

The people affected belong in the analysis

Operating plans can include layoffs, and those decisions affect people, families and communities. “Headcount reduction” does not capture that.

A student asked for more attention to environmental, social and governance (ESG) issues: effects on the environment and people, and how a business is run. I asked where that responsibility should sit, including with the investment firm and with the investors who supply its capital.

Try this: What happened, what might have caused it, and what else could explain it? Name a fact that would change your view.

Then ask 2 separate questions: was the decision justified, and were the people treated with dignity?

Where I land

My aim was not for everyone to leave with the same view of private equity. It was for you to examine your own position and understand why someone else might see it differently.

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