The Truth Behind PE Compensation

Hello World!

Compensation in the PE world can be a bit of a black box. I sometimes get approached by folks who are perplexed by their compensation packages at a middle market PE fund. There is little consistency even across funds of the same size. On the surface, this doesn't exactly make a whole lot of sense. After all, it is easy to calculate a PE firm's revenue: simply take the fund size, multiple by 2%, and there you have a pretty good estimate. Right? Wrong! Here are a couple of the dynamics at play "under the hood" that can have a profound impact on the PE firm's revenue and therefore compensation:

1. Anchor Investors & Side Letters

Economics are not the same for every Limited Partner. Many funds have "Anchor Investors." Anchor Investors earn that status a few ways. Often times the Anchor Investors are the largest Limited Partners by a meaningful scale, accounting for 10% or more of the committed capital. They usually commit capital at the beginning of the fund raise (during the first close) and help build momentum for the fundraising. In return for this risk, Anchor Investors often negotiate a Side Letter. The Side Letter stipulates special conditions or exceptions for that particular LP. While many things can be included in Side Letters, better economics can certainly be one of them. So while 2 and 20 may apply to the majority of the LPs, a couple Anchor Investors may actually be at 1.5% and 15% or lower!

2. Portfolio Company Fee Sharing

It is no secret that PE firms charge a few different fees to their portfolio companies. The usual suspects are a closing fee (initial acquisition), monitoring fees (during ownership), and exit fee (liquidity). These fees are customarily distributed to LPs in one form or fashion. The percentage distributed to the LPs is set at the beginning of the funds life (during fundraising). If a fund has a 100% fee offset, ALL of the fees are distributed to LPs (or used to offset capital calls). An 80/20 construct, which is not uncommon, would permit the private equity firm to retain 20%. This is absolutely massive in terms of a PE firm's revenue and is a large factor in determining how much money is available for compensation, particularly if a great deal of compensation is an annual bonus.

There are a number of other factors at play, such as active legacy funds and their corresponding fee arrangements. However, next time you are negotiating compensation with a PE firm for a senior position, try to get an appreciation for these two dynamics. Ask for a copy of the fund's Private Placement Memorandum, which typically outlines the fee sharing arrangement and the general fund pricing structure. It isn't foolproof, but this could very well explain why your buddy at a similar size fund is getting paid twice as much!

Mod Note (Andy): Best of 2016, this post ranks #36 for the past year

 
West Coast Analyst:

welcome back CB! how's life treating you now

Life is treating me pretty good. Being back in the working world is quite different than the days as a student in business school. Incredibly busy as you may imagine, but I figured I'd poke my head back in here and see how things were going. Website looks so much better! Nice work to Patrick, Andy, and the team!

@the_ferry - Sorry, I can't speak to Fund of Funds compensation structure.

CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 

Mentioned it in the other thread, it's great to see you back. I hope things have been well. It's fantastic to see some of the OG guys back on the forums.

I am permanently behind on PMs, it's not personal.
 

Not to mention the overused "What color tie should I wear to work?" and "Which company's accessories are appropriate for my SA stint?"

GoldenCinderblock: "I keep spending all my money on exotic fish so my armor sucks. Is it possible to romance multiple females? I got with the blue chick so far but I am also interested in the electronic chick and the face mask chick."
 

Great points! Thanks for sharing!

“Let me issue and control a nation’s money and I care not who writes the laws.” Mayer Amschel Rothschild Don't be afraid to give up the good to go for the great.-John D. Rockefeller
 

Very good points - I think very very few if any funds really get 2/20. Another point to add and something I've never seen mentioned on this site in regards to fund fees is Placement Agents.

Funds hire placement agents all the time. I was dumbfounded at the amount of money a placement agent can take for getting a fund raised. Placement agents can charge 2% or more of the total fund size - this reduces the management fee, spread out over time. For Hedge Funds I've seen placement agent fees that are as high as 40% of the 2/20.

Also - some GPs sell a portion of the GP to an anchor LP - this anchor not only gets a lower fee structure but gets a piece of the total GPs revenue.

 

carry is almost always 20%, the very largest LPs (SWFs, Canadians etc) might be able to get a small break, but nowadays they mainly negotiate for first look at co-invests rather than fee discounts.

Large funds usually go for anywhere between 1.5% - 1.9%, sub $1bn funds are still largely 2/20%. Again the largest LPs will get a little below this, but will generally try to reduce their fee burden through co-investments, which obviously have no fees.

Vast majority of funds offset 100% - first time funds and some

 

I recently read a prospectus for a MF that everyone here would know, and they had a ton of fee categories. If you were an investor in a prior fund, and committed big dollars (9 figures or more), you could be charged as little as 1 & 10. Also is it universal that co-invest has no fees? I thought funds could grab 10-20 bps for that occasionally.

 

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