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