Private Equity 2/20 business model

jr.ab's picture
Rank: Monkey | banana points 50

Hi guys,

Just learning finance on my own. Would appreciate if anyone can throw some light on the business model of 2 and 20 of Private Equity firms.

Assume XYZ firm, a PE, raises $100 from investors, takes a 2% cut (of AUM) to take care of its internal operations. XYZ then invests $90 in 3/6 private companies (all unlisted). The cash which can still be invested is 100-2-90= $8

In Year 2, XYZ again charges 2% of its management fee and since it hasn't made any exit, 20% cut isn't charged.

I would like to know on what is the 2% management fee is charged? $98 or $90 or $8?
In the case, 2% is charged on $90, I would like to argue that since the stakes are in unlisted entities they can be hard to value to arrive at the AUM figure.

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Comments (55)

Aug 24, 2015

There is no universal rule and many funds come out with their own basis for management fee. In your example most normal thing that I would expect is to charge 2% of 100 every year until investing period expires. Furthermore, management fee in many cases goes "above" committed capital for investments. So in your example, assuming investing period of two years, in firs year limited partners will spend $92 (90 for investments and 2 for management fee), and 12 in second year ($10 for investments, 2 for management fee).

However, I have seen plenty of variations for management fee calculations, most notable and typical:
1. Different management fee for committed and invested (e.g. 1.5% for committed uninvested, 2% for invested).
2. Different management fee during investment period (usually 3-5 years) and after (another 4-7 years). In most funds I have came across, not only the fee itself (%) is different after investment period, but the basis for its calculation is also different (management fee charged only on invested capital to date, not on committed)
3. Management fee is calculated as [2]% of Net Asset Value, as determined by independent valuer (very rare, normally LPs won't accept that, because valuers often produce very strange results).
4. For listed funds management fee is charged on market cap or market cap linked metric

Etc etc., many variations.

Also, continuting to address your example, you need to define AUM first. Many companies, when talking about AUM, means something like "sum of enterprise values of portfolio companies". Other firms, however (Blackstone is one example) by AUM mean only fair value of equity in their portfolio companies.

Management fee is rarely charged on AUM anyway. For unlisted funds it is normally charged on commited and/or invested capital.

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Aug 24, 2015

Thanks mate for the detailed answer.

Just a follow up question: How do you assess fair value of equity (eg for Blackstone) ? If I have invested $92 in the first year, then how do I assess the market value on $92 which is invested in the portfolio companies?

Best Response
Aug 24, 2015

Fair value is usually estimated using in-house DCF models.
Funds normally have to report valuation to Limited Partners on a quarterly / semi-annual / annual basis anyway, so sum of outputs of these models is used as AUM.
Example from my firm: when we invest in the asset, we have our final acquisition model locked in, say it shows 27% IRR. After acquisition is done, every quarter we update the model (revising our forecast based on new information / actual performance) and discount future cash flows at 27% discount rate. The resulting NPV is your valuation of equity. We report this value to our investors as fair value of fund's holdings. EV of the model goes to assets under management calculation.

Sometimes for valuation (for reportage purposes) external valuers are hired, but from my experience it is very rare.

Given that AUM is sort of "for your information only" the number is not scrutinized in great detail by anyone.

    • 2
Aug 24, 2015

Thanks FairValue for clarifying this. Much Appreciated.

Aug 24, 2015

Great info. SB+

Aug 24, 2015

At least from what I've seen, it's a beginning for negotiations. If an LP wants to be in a fund but believes they can move their weight around, then they can either cut fees (1.5/15) or come up with a different structure (Xmm in the fund under 2/20, FROR for co-invest) that essentially accomplishes the same thing. On the flip side, if a fund is over-subscribed, then it's 2/20 or GTFO.

    • 2
Aug 24, 2015

Thank you for your insight, much appreciated

Aug 24, 2015

Are you referring to the management + incentive fee model or the specific 2/20 cut?

Aug 24, 2015

The specific 2/20 cut. I know that of course not every fund uses it, but is it still commonplace? Do most megafunds recreate their own derivative of it?

Aug 24, 2015

It's a negotiation with every LP. As dmw86 said, the more leverage the LP has (ticket size, brand etc.) the more they will be able to push it down. I'd say that 2/20 would be the best case scenario for most funds.

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Aug 24, 2015

Thank you, this is exactly what I was looking for. You and @dmw86" provided the clarity I was looking for.

Aug 24, 2015

Almost every hedge fund cuts its headline 2 & 20 fees for large or early investors. Many hedge funds already charge 1 & 15 or 1 & 10.

Aug 24, 2015

Very few clients really pay 2 and 20. Virtually every client negotiates its own special arrangement with the fund (much lower fees, slightly lower fees but only if the fund meets an X% hurdle first, etc). And the standard rate at the last several funds I worked at was lower than 2 and 20, but we advertise that number to make clients things they're getting a deal.
So yes, there's already lots of funds charging less than 2 and 20.

Aug 24, 2015

Nice! I guess I should've put, "Will 1 and 10 or 1 and 15 become the standard for HF?''

Aug 24, 2015
Aug 24, 2015

1.5 and 15 is good if you're a young fund. You really have to be proven before you can 'demand' 2/20, and nowadays even then ppl will rarely pay the full fee. I would say standard is already between the 2/20 and 1.5/15, and will probably drift closer to the latter over time

Aug 24, 2015

There has been significant pressure on fees. While people may state that they have a 2/20 model, the effective rate is often notably lower than that. "Founding" LPs (original money, or in some cases, money in within the first year) will commonly receive 1/10. Large commitments (e.g. $200m into a fund with <$1b AUM) will negotiate for preferential terms.

LPs won't push as hard on carry as they will on management fees. It's rare to see someone like Tudor charging 4/23 (one share class is 2.75/27 though). People hate losing money to captive fees; people don't mind paying for performance.

Aug 24, 2015

This thread really allows you to appreciate how insanely good the geniuses at Renaissance Tech. were. If I'm not mistaken, they were charging over 40% in performance fees alone and still outperforming every single year. It's absolutely amazing.

Of course, I say 'were' since they're now closed-off to external investors. One can only imagine what goes on in there.

Aug 24, 2015

It's only the Medallion fund which has been closed. Their other funds are open, but don't exhibit the same performance.

Aug 24, 2015

Did some googling on renaissance tech and all I can say is WOW!!!!!! Their performance is amazing and has been for a long time.

Aug 24, 2015

very very few do 2 & 20 that I've seen. particularly with major firms selling hedge funds to investors, you have the bargaining power of GS, MS, ML, etc., so you can negotiate a fee down just to get on the platform. also, fund of funds that are on platforms have tremendous bargaining power as well, so fee compression is a very real thing.

private equity, not so much, but then again, those returns have justified themselves, so investors don't really seem to care (at least not that I've seen).

Aug 24, 2015
thebrofessor:

very very few do 2 & 20 that I've seen. particularly with major firms selling hedge funds to investors, you have the bargaining power of GS, MS, ML, etc., so you can negotiate a fee down just to get on the platform. also, fund of funds that are on platforms have tremendous bargaining power as well, so fee compression is a very real thing.

private equity, not so much, but then again, those returns have justified themselves, so investors don't really seem to care (at least not that I've seen).

Private equity is down as well, but there it has been more a function of reductions along the edges while maintaining the same 1.5/20 headline economics. So increasingly seeing things like hurdles, reduced management fees on uninvested commitments, etc

Aug 24, 2015

I don't see the PE distinction. Firstly, PE does the same crap. They pay every platform (usually a lot more than HF do) to get distribution. 2nd, doesn't PE have a hurdle rate on the incentive fee? I'm no expert on how PE works, but that already seems to bring down the fees a lot. Finally, PE gets the benefit of no mark-to-market. Investors might be happy or they might not be, but PE is raising new funds on the back of incomplete results. PE is probably in a lot more trouble than people realize vs. HF - a ton more fees are baked into portfolio companies that the regulators are going after hard. Regardless, both under a lot of pressure, but won't be as quick to chance as many think.

Aug 24, 2015

We used to be able to not even have to bake in extra fees into the 2%, we actually had a few other fees completely outside of the 2: acquisition, equity placements, debt financing, disposition/exit, "consulting" to the portfolio companies and a few others. You could charge them to the fund/LP's or to the portfolio companies. They're basically all gone now. If you charge any of these fees to portfolio companies it usually offsets the 2 and goes to the LP's first and the management co doesn't get those fees until the 2 is covered. It's negotiated but it's pretty non-existent in vintages after the recession. KKR and/or Carlysle got into some trouble for this from regulators and, while I don't know the terms of their funds, I highly doubt they're getting them any longer.

Yes, there's almost always an IRR hurdle on the carry so the 20 isn't actually 20 right away, but there are catch ups and waterfalls in nearly every fund doc, but then there are clawbacks and escrow provisions so that the GP can't take carry from exit 1 until the LP's money is returned (used to be far more GP friendly). The 2% annual fee usually also decreases after a certain amount of time-2% during the investment period, 1.5% after 4 years during the hold and 1% during the harvest (round numbers and are negotiated) and once money is returned there's no 2% on that.

Fees are being pushed down but not a ton, at least not as much as I hear about in HF's but I'm not in HF's so that's 3rd party knowledge on my part. Where you get LP's wanting to lower fees is when they're investing in their second, third, etc fund and know the GP has enough money flowing from the previous funds to support the team. My caveat is that I've been in the lower MM-MM market and maybe it's different at the top of the market, but LP's pretty well understand that a PE investment takes a long time to realize and that the 2% is actually used to cover the overhead of investing, operating and exiting the investments. At least at the lower MM level. For example, I know that $15MM of management fees (2% on $750MM) sounds like a lot but that gets eaten up in comp, rent and other overhead pretty quickly. I could completely understand LP's wanting to beat up the GP when you have a $5/10/15B fund and I've heard they're lowering those, but that's also third hand knowledge.

Aug 24, 2015

I should probably clarify: I haven't seen the pe funds on my platform have as dramatic fee reductions, and that should be taken with a grain of salt because brokerage platforms in no way encompass the whole pe universe, but it is refreshing to see a move to no fees on uninvested commitments.

Also completely agree on pay to play, over and over again I see the fund companies with the biggest budgets getting recommended as top picks.

Aug 24, 2015

Do clients ever ask to have their money put in HF? I'm sure this may not happen much since most hedge funds require clients to put in at least 1,000,000 dollars?

Aug 24, 2015

all the time, usually at our recommendation. the minimums are much smaller than you think. many firms have funds both for qualified investors (1mm net worth) in addition to the traditional qualified purchaser (5mm net worth). many funds have a $50k minimum initial purchase and $10k additional purchases, some are $250k/100k, but it's not $1mm (it may be for some institutional funds, but I don't do institutional business).

the HF firms look at it like this: if we get on the platform of Morgan Stanley and Merrill Lynch (UBS does mostly proprietary alts if my memory is correct), we get distribution to close to 30,000 financial advisors and trillions of AUM. prime example: a fund of funds we use got on our platform several years back and one of the top FAs at my firm started using it, he now has $100mm with them. I'm sure whatever that firm paid to be on our platform has come back many times over just from one advisor. all of the firms know this, and that's why they're willing to bend the rules to get distribution.

Aug 24, 2015

the fee structure of hedge funds has become quite bifurcated...most new fund start with fees much lower then 2 and 20 while many old established funds still get away with charging well North of that amount.

Aug 24, 2015

What are some examples of funds that still charge north of 2/20 in L/S world?

Aug 24, 2015

renaissance tech (although someone else said they are now closed to external investors for the medallion fund)? Wonder what the fees are for Citadel, elliott, etc.

Aug 24, 2015

millennium, Brevan Howard, tudor just off the top of my head...most of the funds that are still around after 15-20 years are able to charge more then 2/20 and most of them have shown to be very good investments even at those exorbinant fee levels.

Aug 24, 2015

And that makes sense.

The "old guard" are survivors, which implies they have had historically good returns. Otherwise they would be out of business. So they can charge a premium for their track-record.

Contrast that with a start-up fund that likely has less bargaining power and thus must accept lower fees.

What I am curious about, is what kind of track record is needed for a new manager to then RAISE rates for existing clients?

Aug 24, 2015

Unrelated to your question but Rentech charges like 40% on returns

Aug 24, 2015

How long do most Hedge funds last? 6-10 years? I think I read somewhere that more than 90% don't last 20+ years?

Aug 24, 2015

20 years is 2 lifetimes in Hedge Fund land - even successful ones typically close long before that as the founder retires for any number of reasons. Very few hedge funds have cracked the code to evolve into a long-lived business. Average is definitely <10, and probably <5. If you remove all the ones that never really took off (never got enough money to scale), I'd guess the average is 5-10 yrs.

Also keep in mind that the industry is very young - in 1995 there were probably <100 hedge funds with $500M + AUM, and the ones that have survived are now the giants of the industry.

Aug 24, 2015

Idk about HF but PE will remain 2/20 for a while, IMO. The fee reductions come vis-a-vis co-invest (i.e., "free work"). CalPERs tried to ask for haircuts on 2/20 and a lot of funds balked. Plenty of insurers willing to pay.

Aug 24, 2015

I'd also add, PE funds have begun dropping the 8% pref hurdle rate. https://www.pehub.com/2015/09/advent-proposes-drop...

Aug 24, 2015

To put it frankly, no one pays that. Not even the "small" investors. If you want the best deal and are willing to take more risk that the HF industry already has, invest in funds that are skirting their margin calls. These guys need cash and are likely to forgo all entrance fees and will prob cut their fee on gains as well. However you run the risk of the entire fund imploding and loosing a good chunk of your investment.

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Aug 24, 2015

In short, it will a thing of the past for all but the best funds. Investors will still pay an extra 50-100bps in management fees for an extra 5-10% in performance - but most funds aren't delivering.

It's not the performance fees that are the issue but the management fees and the capital aggregation it encourages.

Aug 24, 2015

Yes, 2 and 20 is far from the norm now, though it differs depending on the strategy. Some good quant funds can still charge 2 and 20 or higher for strategies where a limited amount of capital can be put to work. A couple of the most successful multi-strat funds can also still change high fees. But the vast majority of fundamental equity l/s and distressed funds are closer to 1.5 and 15 for large investors (individuals investing a couple million often pay a higher rate closer to 2 and 20).

Aug 24, 2015

This is deceptive because there are countless funds with tiny AUM that are going to drag down #s. If there were AUM-adjusted figures to look at, it'd be much closer to 2/20.

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Aug 24, 2015
DontMakeMeShortYou:

This is deceptive because there are countless funds with tiny AUM that are going to drag down #s. If there were AUM-adjusted figures to look at, it'd be much closer to 2/20.

nice observation. that's an important distinction

Aug 24, 2015
DontMakeMeShortYou:

This is deceptive because there are countless funds with tiny AUM that are going to drag down #s. If there were AUM-adjusted figures to look at, it'd be much closer to 2/20.

This is very true. I worked for a tiny shop with 75M in AUM and they charged 1/15 but with a 3 year lock-in period. And this was an extremely successful fund averaging 15% returns a year for 20 years. I know people aren't going to believe that a fund can perform so well and still be so small, but it happens.

Aug 24, 2015
glide9811:
DontMakeMeShortYou:

This is deceptive because there are countless funds with tiny AUM that are going to drag down #s. If there were AUM-adjusted figures to look at, it'd be much closer to 2/20.

This is very true. I worked for a tiny shop with 75M in AUM and they charged 1/15 but with a 3 year lock-in period. And this was an extremely successful fund averaging 15% returns a year for 20 years. I know people aren't going to believe that a fund can perform so well and still be so small, but it happens.

How did they retain talent with 1.125mm in management fees?

Aug 24, 2015
HFFBALLfan123:
glide9811:
DontMakeMeShortYou:

This is deceptive because there are countless funds with tiny AUM that are going to drag down #s. If there were AUM-adjusted figures to look at, it'd be much closer to 2/20.

This is very true. I worked for a tiny shop with 75M in AUM and they charged 1/15 but with a 3 year lock-in period. And this was an extremely successful fund averaging 15% returns a year for 20 years. I know people aren't going to believe that a fund can perform so well and still be so small, but it happens.

How did they retain talent with 1.125mm in management fees?

It was a lean shop to say the least. It consisted of one back office employee, two analysts, and the PM himself. And management fees were higher than 1.125M. All in, the fund pulled in around 2.5M a year in fees. The pay was also structured much differently than you might expect because the PM was also the largest investor, so he would make the majority of his money from his investments rather than from management fees. He compensated the analysts accordingly to maximize his total income (as an investor and as a PM).

Aug 24, 2015

Good topic.

My opinion, as some of the other guys have mentioned above me, 2/20 can't be a firm number in the years to come.

I predict that it will be rang pound performance compensation. Management fee will still be in place of 100-200bp, but the performance will look something like:

Return:10%+ YTD
Fee: 15%

Return: 9.99%-8% YTD
Fee: 12%

etc etc..

I think the industry needs to adapt and be more flexible and show there investors that in this environment of poor HF performance that they have a larger vested interest in 'beating the market'. They can do that by having these flex fee schemes.

Personally as an investor I would be pissed if the fund I was invested in made 5% and then charged me 2/20 on top of that.

I know a lot HF implement watermarks and hurdle rates on PM's to protect the investor, but I think a new fee structure needs to be implemented, that takes into consideration losses as well.

Just my $0.02.

  • Only time will tell....
Aug 24, 2015

Even Baupost is not 2/20, so go figure.

Aug 24, 2015

Meanwhile SAC can chuckle with trey and fiddayyy

Aug 24, 2015

Please for the love of god, if you are still in college and speculating just to engage in the topic, stop because you dilute the discussion.

I think the norm, in RE at least, seems to be 1.5% IM fee and possibly a fee break for very large committments. Promotes on the other hand, seem to be all over the place but the norm is 15% all with very unique and creative catch-ups/step-ups.

Obviously this all depends on the manager's track record, vintage of the fund etc..

Aug 24, 2015
Aug 24, 2015