By Christopher Khoury and Eric Peghini
Investors allocate capital with Private Equity Firms in order generate a high rate of return on their invested capital. However, when there are several investors and a separate manager, how much of the profits from investments are investors entitled to? PE firms address this issue by constructing unique and specific payout schemes, called distribution waterfalls, to attract and signal to various types of investors and to accumulate committed capital to enter investments. This article outlines the fee structuring of PE firms and explores the types of distribution waterfalls.
PE Firm Fee Structuring
In private equity there exists a single General Partner (GP) that is the financial sponsor, manager of the portfolio companies and the original investor in the fund. There are also various Limited Partners (LPs) that invest in the fund and typically commit their capital until the fund’s maturity without voting or veto rights. The limited partnership agreement (LPA) is a contract between the parties that lays out the distribution waterfall determining the splits of returns allocated to the LPs and GP upon liquidation of the fund.
For the GP, management fees and carried interest are the magic words as they are their two main revenue streams. Management fees are justified by PE firms in order to finance operating expenses such as rent, utilities and payroll. They are calculated as a percentage of the committed capital and are typically charged on a quarterly or semiannual basis regardless of whether an investment has been entered or not. As part of the profit participation documented in the LPA, carried interest is the percentage of profits that the GP is entitled to receive on top of management fees. Because carried interest is a function of profits, it exists as the chief mechanism to solve potential agency problems between GPs and LPs, since by levering a large portion of GP returns against realized profits, their interests become more aligned with their LPs.
To further refine our discussion, it is important to note that the allocation of profits has been typically prioritized in the following manner:
- Return of capital: distributions go first to LPs until they recover their initial investment
- Preferred return (hurdle rate): further distributions are offered to LPs until the preferred return is reached – typically 5-8% of the fund’s net profit compounded annually
- Catch up: funds are then offered to the GP until it realizes its agreed upon carried interest rate
- Carried interest: the remainder is split amongst LPs and the GP as stated in the LPA
Higher hurdle rates imply higher performance incentives, which benefit the LPs, and in order to show further alignment with LP interests, it is common practice for the GP to also invest between 1 to 5% of the total funds’ assets. Additionally, in the event that the preferred return is not realized upon maturity of the fund, there exists a clawback clause that reimburses LPs via the GPs carried interest. This is another way in which GPs are motivated to maximize returns by putting them in a position where they have more “skin in the game“.
According to this typical fee structure, it has become standard amongst financial sponsors to charge approx. 2% for management fees on the committed capital in the fund and to take a 20% carry (while the remaining 80% is distributed amongst the LPs). This so called ‘2 and 20’ fee scheme is known to be very sticky as it has not substantially changed in the history of PE. However, a recent trend shows that even though the ‘2 and 20’ rule is still in place, the percentages for the management fees have dropped slightly to approximately 1.8% because very large funds, greater than $2 billion in AUM, tend to charge less, and poorly performing sponsors attempt to secure funding by accepting lower management fees. Generally, mezzanine funds rank at the lower-end at 1.5% whereas smaller, first-time funds charge around 2.5% in management fees.
Figure 1: Average management fees for private equity funds by vintage year – Source: Financial Times, Private equity clings to ‘2 and 20’ fee model
Alternative Fee Structures
While some of the best performing and most renowned funds such as Bain Capital and Accel Partners are able to integrate a ‘super carry’ (i.e. higher than the traditional 20%), the rising competition amongst PE funds to attract and sustain investments has fueled the emergence of some new types of fee structures. One special case, which was implemented by Pantheon Ventures in 2017, is a performance-based fee structure, which bundles management and carry fees into a single fee. The performance fee only accrues when the fund outperforms an index in the stock market on a daily basis and similarly, it declines when the fund underperforms this benchmark.
Other types of LP friendly fee structures which are becoming increasingly common include early bird investment discounts to attract early LP commitment of capital. Also more prevalent are structures aimed at hedging risk. Ratcheted carry allows GPs to achieve a higher carry percentage when the fund performs well, but a lower percentage when the fund underperforms investors’ called capital.
There also exist deal-by-deal structures that calculate the carry independently for each transaction. These structures tend to be more manager friendly, as GPs can potentially accumulate large carrying interests despite having underperforming exits, and are common in club-deals and pledge funds, which are PE funds that allow discretionary capital allocation by LPs (often employed by unproven private equity funds without the reputations to source committed capital). Part of the deal-by-deal structure is the diverted carry, which allows the distributions to be diverted to the LP until they recover their initial investment plus their preferred return. The managers are thus allowed to follow-up on the diverted distributions when the gains from exits are achieved. Hence, the downside protection for investors is integrated into the deal-by-deal performance carry. The trend towards individualizing the carry structure continues by offering investors the chance to choose options among the multi-waterfall carried interests. Investors can therefore choose between the trade-off of lower management fees and deal-by-deal carry or whole fund carry with fully charged management fees. In summary, investors may choose between different hurdle rates, management fees and carried interest mixtures.
Finally, a more blatant exception to the traditional management and carry fee structure lies in Special Purpose Acquisition Companies (SPACs) which have become increasingly popular amongst financial sponsors. The appeal to this form of capital deployment lies in the fact that SPACs are less risky than buy-outs (due to little to no leveraging) and they also allow sponsors to invest in industries that conventional buyout funds avoid e.g. CapEx-heavy industries like natural resources. The fee structures change in these types of acquisitions because majority of the capital is sourced publicly (in the form of an IPO). Therefore, the general partner can sell its shares of the SPAC after the retention period and realize 100% of its gains. The SPAC can also disproportionately issue warrants to the PE firm’s professionals to increase those returns. Highly regarded private equity firms including TPG, the Gores Group, WL Ross, Avista and others have utilized SPACs as an acquisition vehicle in the past.
While producing large sums of money and making investors wealthy is important for a PE fund, so is distribution. The breakdown of fee structures informs parties how PE funds generate revenues, how investors are protected and how fund managers are incentivized. As discussed in this article, different fee structures can attract different types of investors. In this respect, while many funds rely on the ‘2 and 20’ rule, new iterations in fee structures are an important point for investors to note when looking for relationships with GPs that they believe to be more appropriate for their return objectives, and likewise relevant to GPs when trying to market their fund to investors.
Authors: Christopher Khoury, Eric Peghini
Editor: Stefan Larsen
- MJ Hudson Carried Interest – going beyond ‘two and twenty’
- Financial Times – Private Equity clings to ‘2 and 20’ fee model
- Duane Morris – Private Equity Fund Fees
- Institutional Investor – Private Equity Firms Get Creative with Fees
- Evercore Wealth Management – It’s Complicated: A Guide to Private Equity Fees
- Weil Global Private Equity Watch – With SPACs Private Equity Sponsors add a New Arrow to their Quiver
- Lexology – A Strategic Comparison of Private Investment Fund Models
- EY – PE firms returning to special-purpose vehicles