At its core, the private equity model is simple:
Real Estate Private Equity firms establish funds that raise capital from sophisticated investors, who are referred to as limited partners, or LPs. The funds are structured as long-term investment vehicles, often requiring limited partner investors to commit their capital for 5 to 10 years.
Private Equity Real Estate firms serve as the general partners (or GPs) of their funds. They invest their own capital along with the capital raised from investors and make all investment decisions for the fund. The funds buy assets that the GPs believe could achieve greater growth and profitability with the right infusion of talent and improvement. Their approach is to put in place the strategies and management teams capable of improving the company’s performance.
Real Estate PE funds typically invest in real estate assets for three to seven years before selling them, hoping to realize a gain on the sale as a result of the increased value they have created during their period of ownership.
When RE Private Equity funds sell investments for a profit, limited partner investors receive the overwhelming majority of the gains. In fact, the PE partners cannot obtain carried interest payments on an investment until they return to LP investors their principal plus a hurdle rate (generally 8 to 10 percent) of partnership profits. After LP investors have received their principal plus a hurdle rate payment on their investment, 80 percent of the remaining profits are allocated to the LP investors and 20 percent to the GPs. The GPs share of gains is commonly referred to as a carried interest.
If there are no profits, PE partners not only receive no carried interest, they lose their own equity investment, and in certain cases may have to payback earlier carried interest payments received on other fund investments that were successful, a process known as clawback.
The size of the gain is proportionate to the increase in value the private equity fund has created over the holding period.
