Question on mechanics of private equity fund manager compensation
So, the basic idea of compensation is easy to understand—2% of the assets under management, 20% of the returns. With $10 million AUM and 25% annual return, you’re looking at compensation to the fund manager (or fund GP) of $200,000 + $500,000 = $700,000 in a given year. Easy enough. However, since PE investments can be especially illiquid, I’m curious how the actual mechanics work.
Let’s say a PE firm buys a business in July 2014, hires a few key people, makes some key investments, lays off redundant employees, and turns the company around and sells the company in, say, February 2016 for a 75% return on investment. I would imagine the administrative tasks to be somewhat daunting in determining how much money went into the investment, in what month it went in, and what the annualized return on investment was. I’d also imagine a fund manager couldn’t get paid until the investment is liquidated, correct? Wouldn’t such an arrangement be an incentive for fund managers to make shorter-term investments so they can get paid out? Conversely, wouldn’t such an arrangement be a disincentive to make some particularly strong longer-term investments?
I’m trying to process all of this. My family is pretty deeply involved in real estate and I’ve tossed around the idea of creating a (small) real estate PE fund but am having trouble wrapping my brain around the mechanics. Any insight is appreciated.
This reply will probably not encompass all relevant points but here are a things I picked up which should answer some of your questions: a) Buying in 2014 and selling in 2016 for 75% ROI: First, whether you can turn around a company in that period is arguable but probably happens from time to time. I wouldn't say it's the norm and if you're lucky/gifted 1 out of 10 investments will get you such stellar performance. Second, finding a buyer who will immediately buy into your turnaround story basically without a track record of financial stability of the company is tough, I guess. b) Administration around investments: Ideally you would set up the company at acquisition already with sufficient cash to finance the turnaround or finance it through the firm's cash flows (which is unlikely in the turnaround you described). If you need to inject cash during your holding period, you will have to account for that. The math is not that daunting; it's similar to a bank account where cash gets in and out and the bank still manages to calculate interest payments. But of course it takes some work which is why most PE firms even at a smaller scale have fund controllers who take care of all that stuff. c) Investment illiquidity: absolutely correct, the 500,000 you mentioned will not occur yearly but the 20% on returns will come only once the investment is realized (i.e. sold). During the investment the PE firm usually charges some management fee to the portfolio company and there is also the possibility for dividends from the company to the PE firm (this also needs to be accounted for in return calculations). In your turnaround example, dividends are again not really an option. d) PE manager incentives: Of course it's great for a PE firm if they can sell within a short time frame for a huge profit but it's simply not that likely that the value of the portfolio company will increase so dramatically over a short time frame. Like your 75% ROI example, it happens but very rarely. Regarding long-term investments, as a PE firm you need to make a trade-off here: invest today and wait for the benefits to come down the road, invest today and hope a future buyer will reward you for this investment or do not invest but risk that future buyers won't be interested because the company is stagnating. e) Money needed to run a PE firm: If you want to run a professionally organized PE firm, you will have quite some costs (travel, offices, admin, salaries...) so the 200,000 recurring income will be gone quite quickly. Now of course if you run a one-man show, that's doable but as soon as you need personnel, you'll need a bigger fund to cover your running cost... So to some degree it's about scale as well.
Hope that helps, I'll be happy to hear some more views.
Thanks for the response. Definitely helpful.
To the example I provided, it was more of an example of an investment taking more than a year and less of an expectation, although a real estate PE may have shorter time horizons.
I happened to be looking recently for articles to explain PE fund management and fees for a non-PE colleague to give them some understanding of how the funds themselves work. The first link is more succinct, the second is really detailed.
http://www.chadbourne.com/files/Publication/3d5a9a56-734c-4d30-a5e4-0a8…
https://www.pli.edu/product_files/EN00000000049875/93868.pdf
Regarding real estate having a shorter timeframe than other types of PE: most REPE is value add on commercial property (include multifamily in that, but not a 2-3 unit building, more like 50-100+ units on the low end), whether it be turning around a property or redevelopment/development and tends to take as long, if not longer, than corporate PE due to the nature of longer term commercial leases, zoning/permitting land, building, etc. If you're flipping sfr's it would be a short time frame: I've never really seen someone raise a fund based on flipping houses but that doesn't mean it can't be done. The reason that an investors typically puts money into a REPE fund is to go for outsized gains and that means they're not buying stabilized properties: if someone's looking for a steady yield they'll buy a liquid REIT and get 5-8%/yr (I have no clue where REIT yields are now so that's just a guess). REITs are often the exit strategy of an investment once the risk has been taken by the PE fund because they're not looking to take as much risk (typically) and they're cost of capital is much less than PE dollars.
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