90 Second Lesson: Fees And Carried Interest, Private Equity Sponsor Compensation Explained

Private equity (PE) investors or limited partners (LPs) make money by investing in companies and yielding a high return based on the company’s increased value. With a minor share of the profits, why is it still so appealing to be a sponsor? After all, the firm or general partner (GP) only invests a minimal percentage into the fund. Private equity compensation comes from two sources: carried interest and fund fees.

Carried Interest: The Generous Distribution Waterfall

The industry standard for fee structure has long been “2 and 20.” This means the general partner (GP) or fund manager charges:

• An annual fee equal to 2% of assets under management
• 20% of the profits of the fund

The 20% profit share is called a carried interest and is commonly paid at the end of the life of the fund.

A private equity (PE) sponsor needs to wait until the hurdle rate is met. This is when the fund reaches a certain rate of return (usually 5-10%) to receive carried interest. This ensures the limited partners (LPs) make back their investment and a decent return.

Sometimes the private equity fund is set up to allow the sponsor/GP to earn its carry on each individual “exit” made (i.e., sale of a portfolio company) instead of waiting until the end of the fund’s life. When this is the case, a clawback provision will stipulate that any overpaid carried interest must be returned to LPs.

Details vary from fund to fund. For example, more established and successful sponsors can ask for compensation terms that are more favorable to them. On the other hand, newer sponsors often offer investors better terms to attract them. Some sponsors set up funds that require the sponsor to pay back a 2% management fee before it can receive any carried interest.

Additional Private Equity (PE) Fund Fees

Sponsors often will charge two types of fees in addition to the two outlined above. These fees can pay for salaries and other operational costs: (a) management fees and (b) transaction fees.

• Management fees kick in once the private equity fund purchases a portfolio company. Once  the PE fund owns a company, the sponsor will charge the portfolio company a yearly fee for the time and attention it spends on the portfolio company.
• Transaction fees (sometimes called deal fees) are simply additional fees a sponsor may charge to a portfolio company in connection with certain transactions.

These fees and carried interest make up the private equity compensation structure. Layers of fees tend to come under scrutiny as different funds underperform.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Leveraged Finance
2. Restructuring, Insolvency & Troubled Companies
3. All About Asset Allocation

This is an updated version of an article originally published on August 19, 2019.]

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