Now that we have discussed the Seller versus Private Equity Fund Valuations and Negotiations, let us move on to other important topics of The Private Equity Market. For today’s article, we will discuss the Compensation of Private Equity GPs. Let’s get started.
Compensation of Private Equity GPs
In the most common scenarios, general partners of a private equity fund can earn different types of income. For one, they can earn a fixed income. This income is independent of the performance of the fund. Regardless of how the fund is doing, the fixed income is still the same.
Secondly, partners can earn a variable income. It is a function of that performance. There are also what’s called management fees. Usually, these fees are paid from the committed capital and are fixed.
Committed capital is the money that limited partners provide. This is usually composed of lifetime fees and investment capital. It is important to know that the arrangement for the management fee is between the general partner and the LP. This can vary depending on what they have agreed on.
For instance, the management fee could be a fixed percentage over the life of the fund. Or, in more common instances, the fee could decline over that time period.
So, are the fees calculated? Well, they are usually calculated through means of applying the relevant percentage to some base minus the cost basis of investments that have already been disposed of. This could be the committed capital or another alternative such as net invested capital, which is defined as the invested capital. Invested capital is capital that has already been invested.
Variable Fees: Carried Interest
Now, there are also other ways for general partners to earn income. Aside from fixed management fees, GPs also have the right to several variable incomes. These are most commonly referred to as performance-based income.
Usually, and the most controversial is carried interest. This is earned from gains on the transactions that were conducted by the general partner. Now, as for how the general partners can actually earn income from this source usually depends on the agreement with the LPs.
For instance, it is possible that the general partner cannot earn this type of income unless the limited partner has already received their capital. Additionally, if a hurdle rate was agreed to, the amount could be higher.
Now, a carry level is the percentage of the applicable profit that is used to calculate the earnings of a general partner. Commonly, carry levels are at twenty percent.
Oftentimes, you would hear that general partner are paid based on 2/20. That means that the 2 would be the fixed percentage while the 20 refers to the variable component that is based on the 20% carry level.
There will also be instances where general partners are allowed to take some profits early. This is resolved by the carry timing.
However, if the limited partners do not receive their capital, then it is possible for them to get back some of these early paid profits. This is, of course, contingent to the fact that the original agreements between general and limited partners have clawback provisions.
Variable Fees: Monitoring and Transactions Fees
There are also monitoring and transaction fees. These are what make up the remainder of the variable income that the general partners receive. General partners do the monitoring.
They oversee the operations and performance of the companies that they have acquired. Usually, limited partners are also entitled to these fees. In fact, they receive the bulk of the fees, which is at eighty percent most of the time. These fees are usually based on some multiple of financial performance measures, such as EBITDA.
Additionally, for each completed transaction, the general partners have the right to charge a transaction fee. It can be structured so that there is a total transaction fee and part of the total is shared with the limited partners.
LP “Activism” and the Evolving Private Equity GPs Business
There was a time when limited partners were relatively passive investors. They invested their capital and waited for the automatic high returns.
The strong equity markets gave the general partners, or private equity managers a way to easily meet the expectations of the clients or the limited partners. However, all of these changed when the economy and market turned down.
These days, private equity managers or general partners have to work harder for their returns. Oftentimes, they find themselves under closer scrutiny from the limited partners.
As expected, the limited partners want more detailed breakdowns or explanations. They want to know more about each transaction, and how each of those will generate good returns. Additionally, LPs also want to be updated on the progress of each transaction.
This is especially true for government pension fund limited partners. It may also be less applicable for university endowment limited partners.
This is because government pension funds are the leading providers of capital to private equity funds. It is also true that limited partners are more active now than they used to be. In the past, they were almost totally inactive.
Activism that Requires Private Equity Firms
Part of that activism is requiring private equity firms to cancel some of the charges that had contributed in the past to slip past inattentive LPs. As we have already discussed, when the market is strong, and the limited partners see good returns, they tend to be less keen on monitoring fees and expenses that are charged by the general partners.
However, this is very unfortunate because limited partners own an obligation to the employees they represent to receive the highest returns they can. They also have the obligation to prevent general partners from siphoning off money through the fees of the limited partners they should have not agreed to pay in the first place. This is an issue that the Securities and The Exchange Commission has been focusing on more.
In the next article, we will continue our discussion of The Private Equity Market. And we will focus on Private Equity Fund Partnerships and “Club Deals”. See you then!
© Image credits to Tim Mossholder