10 versus dollars in millions from minus 6 to 6 with plots for capital calls, distributions, and cumulative net cash flow."/>Early in the investment period, the J-curve has a steep negative slope, as a fund’s initial investments and management fees (paid on committed capital) result in large cash outflows for its LPs. As the fund begins to exit its portfolio company holdings, distributions of capital slow the J-curve’s descent; some funds may in fact show a positive slope before the end of the investment period. While the low point of a J-curve is theoretically defined as the fund’s total committed capital, J-curves rarely dip below 80 % of committed capital due to the time required to deploy capital and early divestment activity. In fact, many funds do not even reach a net drawdown of more than 50 %.
Following the start of the divestment period, the J-curve turns upward as exit activity picks up and invested capital plus a share of profits are returned to LPs. Capital called for follow-on investments and management fees continue to generate small LP outflows during the divestment period. As soon as the J-curve crosses the x-axis, the fund has reached breakeven; the final point on the J-curve represents an LP’s total net profit generated by the fund.
While LPs will attempt to optimize their portfolio allocation, modeling cash flows as well as net asset values remains challenging, given the blind pool nature of the funds and the overall scarcity of data in PE. The secondaries market nowadays offers a realistic avenue to add liquidity, shorten the J-curve and manage a PE portfolio proactively.
THE FEE STRUCTURE AND ECONOMICS OF PE
OR WHO EARNS WHAT?
The typical fee structure of a PE fund is designed to align the economic interest of the PE firm and its fund investors. The fee structure in PE is commonly referred to as “2 and 20” and defines how a fund’s investment manager and GP – and in turn its PE professionals – are compensated: the “2 %” refers to the management fee paid by the LPs per annum to a fund’s investment manager while the “20” represents the percentage of net fund profits – referred to as carried interest or “carry” – paid to its GP. The clear majority of profits, 80 %, generated by a fund is distributed pro rata to a fund’s LPs. As long as carried interest remains the main economic incentive for PE professionals, their focus will continue to be on maximizing returns, which in turn benefits the LPs. Exhibit 1.7 visualizes the flow of fees and share of net profits to the entities involved in a PE fund.
Exhibit 1.7 PE Fees and Carried Interest
Returns in PE are typically measured in both internal rate of return and multiples of money invested.20 Given a fund’s cost structure, its net return – that is, the return on capital generated by the fund net of management fees and carried interest – is the relevant metric for its investors and LPs will ultimately define success on that basis at the end of the fund’s life.
We take a detailed look at fees and carried interest below.
MANAGEMENT FEES: A PE fund’s investment manager charges the fund – and ultimately its LPs – an annual management fee to cover all day-to-day expenses of the fund, including salaries, office rent and costs related to deal sourcing and monitoring portfolio investments. In the early days of PE, the management fee charged was an almost consistent 2 % per annum, yet currently it ranges from 1.3 to 2.5 % depending on the size and strategy of a fund and the bargaining power of the PE firm during fundraising. For example, it is accepted that smaller, first-time funds will charge higher fees to cover their fixed costs, while large funds and mezzanine funds often charge lower fees. Since the global financial crisis of 2008 management fees have come under pressure, sometimes in an indirect way, through a sizable increase in free or discounted co-investment opportunities for LPs.21
Management fees accrue from a fund’s first closing onwards and are usually paid either quarterly or semi-annually in advance. Management fees are charged on committed capital during the investment period, and on net invested capital after the investment period; the rate charged on invested capital may step down from the initial percentage.22 This fee structure causes fee revenue to drop over the lifetime of a PE fund as capital is deployed and exits occur. Early in a fund’s life, management fees are typically drawn directly from investors’ committed capital, while proceeds from profitable exits may be used to offset management fees later in a fund’s life.
OTHER FEES: An investment manager may charge additional fees to the fund, particularly in the context of a control buyout. The main fee categories are transaction fees linked to a fund’s investment in and exit from a portfolio company and monitoring fees for advisory and consulting services provided to portfolio companies during the holding period. Other fees also include but are not limited to broken deal fees, directors’ fees, and other fees for services rendered at the fund or portfolio company level. Over the last decade, management fee offsets have increasingly been included in LPAs; when these offsets are in place, management fees charged to the LPs are reduced by a percentage of “other” fees collected by the fund – historically between 50 and 100 %, now trending towards 100 %. These offsets reduce the fee burden for LPs and shift a portion of the fee-based compensation from the GP to the limited partnership as a whole.
CARRIED INTEREST: Proceeds from successful exits are distributed to a fund’s LPs and its GP in line with a distribution “waterfall” set out in a fund’s LPA.23 Carried interest is the share of a fund’s net profits paid to its GP – typically 20 % – and serves as the main incentive for a PE firm’s principals. In a typical distribution waterfall, PE funds will return all invested capital and provide a minimum return to investors – a fund’s hurdle rate24 or preferred return – before any carried interest is paid out to the GP. After the hurdle rate has been reached, PE funds will typically include a “catch-up” mechanism that provides distributions to the GP until it has received 20 % of all net profits paid out up to this point. Thereafter, all remaining profits are split at the agreed-upon carried interest percentage (80−20). Should a GP for any reason receive more than its fair share of profits, a clawback provision included in a fund’s LPA requires GPs to return excess distributions to the fund’s LPs. Exhibit 1.8 shows the basic steps common to all distribution waterfalls.
Exhibit 1.8 PE Fund Distribution Waterfall
The industry uses two standard models to calculate distributions to LPs:
● All capital first: Also known as a European-style waterfall, this structure entitles a GP to carried interest only after all capital contributed by investors over a fund’s life has been returned and any capital required to satisfy a hurdle rate or preferred return has been distributed.
● Deal-by-deal carry (with loss carry-forward): Also known as an American-style waterfall, this structure entitles a GP to carried interest after each profitable exit from a portfolio investment during the fund’s life, but only after investors have received their invested capital from the deal in question, a preferred return and a “make whole” payment for any losses incurred on prior deals.
A detailed
See Chapter 21 for further details on this co-investment trend.
Net invested capital consists of contributed capital minus capital returned from exits and any write downs of investment value.
Please refer to Chapter 16 Fund Formation for a detailed description of distribution waterfalls and examples of carried interest calculations.
The hurdle rate, typically set at 8 %, will be negotiated during fundraising. A fund is only “in the carry” (i.e., performance incentives for the GP kick in) once it has reached an annual return of 8 %.
