Economics of a Fund
Private equity firms account for a substantial amount of the total global M&A activity every year. If the firm is successful, it’s a very lucrative business, but how exactly do PE firms make money?
The main sources of income are described below. However, keep in mind that all of these terms are negotiable and the examples are used only for illustrative purposes.
All private equity firms charge a management fee. Management fees are used to pay salaries, office rent, supplies, IT expenses, and other operating expenses.
The most typical fee is 2% per year for the first five years, and then 1% per year for the last five years, based on assets under management (AUM). So, if a PE firm has a $500mm fund, they will receive $75mm in total management fees over the life of the fund ($10mm per year for the first five years, and $5mm per year for last five years).
You can see that if a firm manages billions of dollars, the management fee can become much bigger than what the firms operating expenses are. This is why many Limited Partners (LP; investors in the PE fund) are hesitant to pay large management fees.
Another important thing to note is that every dollar that is drawn from management fees is a dollar that’s not available for investing. In the example above, even though we have a $500mm fund, the PE firm would only have $425mm to invest ($500mm minus $75mm in management fees). However, even though the fees are drawn upfront from the fund, they are eventually paid out of profits (in case the fund is successful). This becomes important when calculating profit sharing and is explained in more detail in the carried interest section.
Carried Interest (Carry)
Carried interest refers to the performance-based fees that funds will charge its investors. Typically, a PE firm will charge a 20% carry on the fund’s profit.
For example, let’s imagine a $500mm fund. If over the lifetime of the fund, the PE firm increases its value to $1,575mm, it will charge 20% carry on the profit of $1B ($1,575mm of final value minus $500mm of original fund size minus $75mm of management fees). This means that the PE firm will get $200mm of the profits, and the investors will get $800mm (plus their original $500mm for a total of $1.3B).
Carry serves as a tool to align incentives of the PE firm and investors. In other words, PE firm can only make a lot of money from carry if it made a ton of money for its investors.
How management fee affects carry?Remember from our Management Fee section example, that the fund had only $425mm to invest after drawing $75mm in management fees. These fees are drawn upfront from the fund because the firm needs to pay its bills before it knows the final performance of the fund (which is 10 years later).
However, if the PE firm successfully invests that $425mm and turns it into $1,575mm, the final profit of the fund will be calculated as the difference between the final value ($1,575mm) minus the original fund size ($500mm) minus the management fees ($75mm), for $1B of total profit that is left for sharing between the LPs and the PE firm.
Hurdle Rate.Hurdle rate is a minimum amount of return that LPs require before they allow PE firm to collect carry. Typical hurdle rate is 8% per year.
For example, for a $500mm fund that operates for one year, LPs require a minimum return of $40mm. Therefore, if the PE firm increases the value of the fund to $530mm, it won’t be able to collect 20% carry on $30mm of profits because it didn’t reach the hurdle rate.
On the other hand, if the PE firm increases the value of the fund to $600, it will be able to collect 20% carry on $100mm of profit because LPs will get $80mm in that scenario (which is greater than their minimum required return of $40mm).
What happens if a PE firm increases the value of the fund to $545mm? This is a situation in which the payout structure depends on the agreed upon terms between LPs and the PE firm. In general, LPs will get their $40mm back first, and the PE firm will collect all profits above that number until it catches up to the 20/80 split. So in this case, PE firm would collect all $5mm above $40mm and would keep collecting profits up to $10mm ($10 / $40 = 20% / 80% split) before it starts sharing them again with the LPs.
See the table below for a few more examples (assuming $500mm fund and 8% hurdle rate):
European vs. American Waterfall.Waterfalls refer to the distribution mechanics of the carry. A European style distribution structure means the carry gets paid out at an aggregate fund level, while the American style distribution structure means the carry gets paid out on a deal-by-deal basis.
American waterfall can be very attractive to the PE firm’s partners because it allows them to get carry on an ongoing basis (as opposed to waiting until the end of the fund lifecycle). However, it also introduces some challenges. What happens if a firm pays out carry for some early successes but then loses money on later investments? It would not be fair to collect carry on successful deals, but not be responsible for losses on bad deals. This is why clawbackprovision exists. It states that the partners need to repay some of their carry for bad deals in order to normalize the final amount of carry payout. In the end, European and American waterfall should end up paying the same amount of carry to the PE firm, but the American waterfall allows the firm to start collecting the money early.
Deal fees, also known as transaction fees or success fees, are fees charged by the PE firm for all the work that the PE firm needed to do to close a transaction (e.g. due diligence) as well as to compensate the firm for all “dead deals” (see below for explanation). They typically range from 2 – 4% of the transaction value.
For example, if a firm charges a 3% fee on a $200mm deal, it will receive $6mm in cash for completing the deal.
It is worth noting that these fees have become very controversial because they misalign incentives between investors and the PE firm. After all, why would the PE firm need to get extra compensation for doing its job (assuming the salaries are paid from the management fees)? The biggest argument for keeping the deal fees is that somebody needs to pay for all diligence expenses for “dead deals” (see below for explanation). However, charging deal fees incentivizes the PE firm to close as many large deals as possible since the fees will be paid out regardless of the investment performance. This is why many LPs are renegotiating their terms with private equity firms in order to avoid paying these fees in the future.
Dead Deals.These are the deals that the PE firm did a lot of work on but didn’t end up closing them. This can happen for a variety of reasons, including not paying the highest price for the company, finding concerning information about the company, or even a significant negative shift in the economy (e.g. recession). However, even when a PE firm doesn’t close a deal, it can incur significant due diligence expenses during the process (e.g. consultants, lawyers, site visits, etc.). Since these expenses can balloon quickly, often times (especially for smaller funds) management fees are not enough to cover all of the deal related expenses. This is one of the main reasons why the PE firms still charge deal fees, but as mentioned above, this term is becoming highly negotiable.
Monitoring fees are simply annual fees charged to a fund’s portfolio companies for ongoing advisory and management services. These fees are typically to be paid in cash by the company, as agreed upon at the time of the acquisition. They are defined either as a fixed amount or a percentage of profit (e.g. EBITDA). In case that they are calculated as a percentage of profit, there is typically a minimum fixed amount that needs to be paid in case that the profits go down.
For example, the monitoring fee can be defined as 2% of EBITDA or minimum of $1mm. In case that the company’s EBITDA is $60mm, the fee will be $1.2mm. However, if the company’s EBITDA goes down to $40mm, the fee will be $1mm (vs. $0.8mm which would be implied by 2% of $40mm).
Similar to deal fees, monitoring fees are also becoming more and more controversial because every dollar taken out of the company is affecting the final equity value of the investment.
Putting it all together
Let’s assume we manage a $500mm fund with the following fee characteristics and deal activity:
- Charges 2% management fee for the first five years, and 1% for the last five years
- Charges 20% carried interest (carry)
- Makes 10 investments of $122.5mm (assuming that it can raise $836.8mm in debt to finance transactions)
- Charges 3% deal fee per investment
- Holds each company for 5 years
- Charges $1mm monitoring fee per year per company
- After it exits all investments, it has $1,575mm in value
First, if we charge 2% management fee on $500mm for the first 5 years, and then 1% for the last five years, the fund will collect $75mm in management fees, leaving us with only $425mm to invest.
Second, we assume we invest in 10 deals at $122.5mm ($42.5mm of equity + $80mm of debt). At 3% deal fee per investment, the fund would collect $36.8mm in deal fees. Let’s assume that these fees would be financed by adding $3.68mm of more debt per transaction. Therefore, in reality, we would need to raise $836.8mm in debt for all 10 transactions.
Third, since we own each company for 5 years, we will make $5mm in monitoring fees per investment, which leads us to $50mm in monitoring fees for all 10 investments.
Finally, since the fund has created $1B of profit for the investors ($1,575mm of final value minus $500mm of original fund size minus $75mm of management fees), the PE firm is entitled to 20% carried interest on this profit. This means that the PE firm will earn $200mm and the LPs will earn $800mm (plus get back their original $500mm for a total of $1.3B).
In this scenario, the private equity firm would make $75mm in management fees, $36.8mm in deal fees, $50mm in monitoring fees, and $200mm in carry, for a total of $361.8mm in combined fees.
In this particular example, it’s easy to see that out of $361.8mm in total fees, only $200mm is performance based (carry). In other words, if a PE firm made all bad investments, and lost all of the money, it would still take home $161.8mm under this arrangement (it wouldn’t get any carry because carry is only paid out based on profit).
As you can imagine, this is unacceptable to the LPs, but since carry amount isn’t known until the portfolio companies are sold, LPs allow PE firms charge a mix of management, deal, and monitoring fees in order to pay for their operating expenses.
However, in recent years, LPs started asking for rebates of those fees once the carry gets paid out, resulting in a much smaller profit for the PE firms. As mentioned above, all of these terms are heavily negotiable and differ greatly from firm to firm, but one thing is for sure – LPs have no problem with paying for great performance, but they are also getting much smarter and are not letting PE firms get away with charging excessive fees just for doing their job.