The formulas, tricks and trade secrets of Private Equity

Fee Structure 2 20

Sample Chapter

The 2/20 rule refers to a 2% management fee and a 20% outperformance fee. That is, investors typically pay 2% of committed capital to the management company to manage the fund and 20% of returned funds above the initial capital as an incentive.

I mention committed capital, because in most private equity funds, investors commit capital rather than invest capital. Their capital is called as required by new investments. So in practice, a firm may not invest a single dollar for two years, but based on committed capital of say $1b, $20m a year is paid as management fees to sift through investment opportunities. This is one of the many beauties of the private equity model (for private equity firms at least).

I once heard a prominent partner of a large New York private equity firm say, “There are three certainties in life: death, taxes and a 20% carry.” Of course the monetary value of the carry isn’t a certainty, but what he was inferring is that the private equity industry will stick by its 20% carry rule irrespective of what anyone else thinks because it’s their livelihood.

As for the 2% management fee, it keeps the fund running; it pays the staff, the lease on the office, the electricity bills, and those infamous lunches that introduce new investees to the big time. Since the fee is fixed, employees are rarely paid bonuses in the private equity space; the 20% carry is their incentive. Additionally, distributed funds from exited investments aren’t included when calculating the management fee (even that would be too audacious for a private equity firm); only invested or uncalled capital attracts fees.

The 2/20 rule sounds simple enough, but it really is the lifeblood of the industry. Some of the best strategic thinkers go to private equity because of the combination of small teams, large funds and the 20% carry. Equally, the 2% management fee is vital to facilitate great deals, mainly because the carry is contingent on many variables and often not paid for five or so years into a fund (until exits occur).

The misplaced 2 and 20 fee structure incentive I sit down with is, of course, the management fee. the two and twenty of assets under management that visit the fund manager, in theory, to support infrastructure till liquidity events get everybody paid. And obtaining wealthy the two hundredth is contingent on performance. 2% has, with larger funds, become over simply infrastructure support. Moreover, after you begin seeing $54 billion, $27 billion and $131 billion funds, two hundredth appearance downright silly. Certainly, 2 and 20 fee structure funds don’t seem to be scaling their infrastructure up in a very linear fashion once around $2 billion in managed funds. That two hundredth appearance a lot of and a lot of like pure “bonus cash.” And bonus cash not contingent on performance, solely on fund raising capability. Suddenly, you have got an incentive downside (the incentive is to boost lots and develop solely restricted infrastructure) combined with a final spherical downside. Who cares if the $231 billion fund folds. once four years they’ve pocketed up to $135 billion simply in management fees. That takes a number of the sting out of being unable to boost $1 billion subsequent year owing to low IRRs.

Since private equity funds are called as alternative investments, they are proscribed to deep pockets, who will handle the bigger risk. Each feature fee structures variations on the “2 and 20″ formula within which partners take a 2% fee for managing the assets they management and slice out of any incremental profits they deliver.

Another potential amendment is whether or not private equity companies charge their management fees on committed capital or cash that has truly been invested. Most private equity shoppers support the payment of a twenty p.c profit participation, conjointly referred to as the carry, as a result of they require to encourage managers to create cash.

Under 2/20 fee structure, investors usually pay two hundredth of the committed capital to the management company to manage the fund and two hundredth of the came funds on top of the initial capital as an incentive.

The general consensus appears to be that something between 2-3.5% management fees is that the commonplace norm keeping the changing market situation. As for the two hundredth carry charge, it’s all the way down to 12-15% bracket reckoning on the GP’s performance records.

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