Private equity investors or limited partners (LPs) make money by directly 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.
The industry standard, in terms of fee structure, has long been “2 and 20.” This means that the general partner (GP) or fund manager charges: (a) an annual fee equal to 2% of assets under management plus (b) 20% of the profits of the fund.
The 20% profit share is called a “carried interest,” and it is commonly paid at the end of the life of the fund. A PE sponsor must wait until the hurdle rate is met, in which the fund reaches a certain rate of return (typically 5-10%), to receive carried interest. This ensures the LPs make back their investment and a decent return.
Sometimes, however, the private equity fund is set up to allow the sponsor/GP to earn its carry on each individual exit (i.e., sale of a portfolio company) made along the way rather than waiting until the end of the life of the fund. 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, with more established and successful sponsors being able to dictate compensation terms that are more favorable to them. Likewise, newer sponsors will often offer better terms to their investors to attract them. For example, some sponsors set up funds that require the sponsor to pay back the 2% management fee before it can receive carried interest.
Sponsors often will charge two additional types of fees in addition to the two outlined above: (a) management fees and (b) transaction fees. These fees essentially pay for salaries and other operational costs.
These fees, combined with carried interest, make up the private equity compensation structure. In recent years, layers of fees have come under increasing scrutiny as many funds have underperformed the market as a whole. Mega-investor Warren Buffet famously wagered (and won) a bet that a low-fee index fund of the S&P 500 would outperform a group of hedge funds selected by his opponent in the wager, asset manager Protégé Partners. Over 9 years ending in 2016 the index fund returned a compounded annual increase of 7.1 percent versus 2.2 percent from the hedge funds.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: What is a Private Fund and Alternative Assets Part 1: Investing in Venture Capital, Private Equity, and Hedge Funds.]
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