In private equity, the term “2 and 20” refers to the traditional compensation structure for private equity funds: 2% management fee and 20% performance fee (also known as “carried interest” or “carry”).
 
In this post, we will explore management fee.
 
Historically, management fee was intended to provide fund managers with enough money to pay modest salaries, rent modest offices and incur modest expenses.  It was said that management fee was intended to let the fund manager “keep the lights on” and that the performance fee (known as “carried interest” or “carry”) was where the fund manager made its money.  While investors in private equity funds (known as “limited partners” or “LPs”) continue to take this view, terms in fund documents (known as the "limited partnership agreement" or "LPA") relating to management fee have become more complex.
 
Let’s dig in.
 
In previous posts, we have explored committed capital and the investment period:

• LP Corner: On Committed Capital, Called Capital and Uncalled Capital
• LP Corner: the Four Phases in the Life of a Private Equity Fund
• LP Corner: Private Equity Cash Flows from the LP Perspective

 
We will look at management fee in three phases of a fund’s life: the investment period, the harvesting (or realization) period and during extensions.
 
Investment period
The vast majority of private equity funds (here, we’re discussing buyout, growth equity and venture capital funds) charge 2% of committed capital per year during the investment period, which has traditionally been 3-5 years, but I’m seeing this extend to 6 years.  For example, a $200 million fund with a 2% management fee will provide the manager of the fund (also known as the “general partner” or “GP”) with $4 million per year.  Management fee is always paid quarterly in advance.  In our example, this means that the fund will pay the GP $1 million in management fee per quarter, at the beginning of the quarter.  This management fee pays for the salaries of the investment team, office staff, office rent, utilities, etc.  Part of the rationale for this fee is that during the investment period, the GP is going to be very busy sourcing and evaluating deals and making investments.
 
Harvesting (realization) period
After the investment period, the fund will no longer invest in new companies, but will continue to support and invest in existing portfolio companies.  Also, the GP will have likely raised a new fund, which will also be generating management fee.  During the harvesting period, management fee will generally decline, and there are many different ways management fee is determined during this harvesting period.  Often, the management fee will stay at 2%, but the base is changed from committed capital to invested capital.  Other times, the management fee will decline by some percent each year, so that in the first year after the investment period the fee drops to 1.75%, the next year 1.5%, the next year 1.25%, etc., with some floor, such as 1% of committed capital.  There are many different permutations of management fee during the harvesting period.
 
Extension period
Private equity funds are usually 10 year funds, but the GP often has the right to unilaterally extend the term of the fund by one or two years.  This is referred to as a “10-year term with two 1-year extensions.”  Usually, during the two GP-option extensions, the formula for management fee in the harvesting period continues.  It is when funds still have active investments at the end of 12 years, does management fee become a further issue. 
 
To extend a fund’s life after the 10 year term and the two 1-year GP extensions, the GP will usually need to obtain the approval of the limited partner advisory committee or of a majority-in-interest of the limited partners (see the Glossary for an explanation of this term).  Now that the GP needs the approval of the LPs to extend the term, the LPs will negotiate the management fee for this additional extension period.  Many LPs take the hard-line position that the GP should not receive any management fee during these additional extensions, and will vote against any extension to force the fund into liquidation.  Others will negotiate with the GP on a management fee based on the remaining portfolio.  Often this is a very reduced management fee, such as 1.25% of the lower of cost of the remaining investments or their fair value.  The management fee can also be based on a budget or some other basis.
 
Additional Notes:

• Smaller Fund Management Fee.  Some smaller funds ($100 million in committed capital and under) may charge a higher management fee of 2.25% or 2.5%, and larger funds (over $1 billion in committed capital and over) will charge lower fees, usually around 1.2% to 1.5%.
• Large Fund Management Fee.  Some large funds are now offering fee and carry options for LPs, such as a choice between a 2% management fee and 20% carry or a 1% management fee and 30% carry.  Some LPs prefer the latter (10%/30%) option as they feel it better aligns the interests of the GP and the LPs.
• Fee on Called Capital Only.  A few funds have offered management fee only on called capital.  This is very appealing to LPs as it means the LP pays fees only when the GP is putting the money to work.  This has happened in only a few unique circumstances, such as in a follow-on fund (a fund raised to support the investments of an earlier fund that has called most or all of its capital).
• Breaks.  Some funds offer one-off management fee breaks for “first closing” investors that invest a certain minimum amount.  This is meant to incentivize investors to invest early, at the first closing.  It’s a tool to build momentum for fundraising.  For example, an investor who commits $20 million to the fund in the first closing may pay a reduced 1% management fee for the first year of the fund.
• Successor fund.  It is customary for GPs to raise successor funds prior to the end of the investment period.  Many LPAs provide that when this occurs and the GP starts to receive management fee from the successor fund, the management fee for the current fund will start stepping-down.  
• Expenses.  What expenses are paid by the fund and what expenses are paid by the GP are often heavily negotiated terms.  Issues such as travel, compliance, administration and other items are negotiated as part of the limited partnership agreement.
• Fund-of-Fund Management Fee.  Funds-of-funds fees are usually around 0.75% to 1.00% of committed capital.  Funds-of-funds fees have been under a lot of pressure over the last several years.

I have clients who are new to investing in private equity, and one of the first conversations we have is about "what is private equity"?

Private equity, generally speaking, is an equity (stock) investment in a privately-held company.  Private = privately held company.  Equity = stock.  It's a little more complicated than that, but that's a useful starting point.

The term "private equity" can be used in different contexts and can mean different things.  I group these in 4 categories:

Asset Class.  First, the term "private equity" can refer to the private equity asset class.  An asset class is basically a group of assets that have similar characteristics and behave similarly.  Common asset classes include: public stocks; public bonds (also called fixed income), cash, real estate and private equity.  There are also others, and different investors may define asset classes differently.  This usage of the term "private equity" typically occurs when investors are discussing allocations to asset classes - for example "we are allocated 40% to public equities, 40% to public fixed income; 18% to private equity and 2% to cash."  Within the private equity asset class, there are different strategies, including venture capital, growth equity and buyouts.  For more on venture capital, growth equity and buyouts, please see my posts "LP Corner: What is Venture Capital? Here's My Definition", "LP Corner: Venture Capital vs Growth Equity - A Comparison" and "LP Corner: What are Buyouts? Here's my Definition."
 
Transaction.  Second, the term "private equity" can refer to a type of transaction – which is primarily buyouts.  However, it can also describe a growth equity investment.  However, the term "private equity" isn't used to describe a venture capital investment.  Venture capital is a unique strategy within the private equity asset class, and the term "venture capital" is used very specifically.
 
Firm.  Third, the term “private equity” can be used to describe an investment firm.  A “private equity” firm is one that primarily invests in buyout transactions, but the term can also apply to firms that invest in growth equity.  One doesn’t use the term “Private Equity firm” to describe a venture capital firm - those are simply called "venture capital" firms.

Industry.  Finally, the term "private equity" may refer to the private equity industry.  The private equity industry starts with the private equity strategies of venture capital, growth equity and buyouts and also includes investors in the private equity asset class, such as public and private pensions, sovereign wealth funds, corporations, foundations, endowments, family offices and high net worth individuals.  Also included are firms and funds - venture capital firms, growth equity firms and buyout firms, as well as corporate venture capital efforts.  Add in service providers such as attorneys, accountants, valuation firms, database firms, back office support, etc. as well as industry groups (such as the NVCA and ILPA), conference providers and the press, and you end up with a very large industry.
 
So you need to understand the context in which the term is being used.

I hope this explanation is helpful.

© 2018 Allen J. Latta. All rights reserved. ​

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance - This blog post.
• LP Corner: Gross vs Net Returns
  

We have now discussed the three metrics that are primarily used to evaluate the performance of private equity funds: (1) the multiples TVPI, DPI and RVPI; (2) IRR; and (3) PME.  We will now discuss how to use these metrics to evaluate the performance of private equity funds.
 
Overview
There are several ways to evaluate the performance of a fund, or a portfolio of funds, with the main methods being:

• Absolute return.
• Comparative return to other similar funds (Quartile Analysis).
• Comparative return to the public markets (PME Analysis).

 
Absolute Return
Absolute return refers to a specific threshold requirement for a fund’s performance.  For example, some LPs may say that they expect a 3.0x TVPI and 30% IRR net return from early stage venture capital funds, or a 2.0x and 20% return for buyout funds.  If a fund’s return exceeds these metrics, then it “outperforms” the metrics.  If a fund’s returns are less than these metrics, then the fund “underperforms.” 
 
A note about absolute return.  Most funds experience a J-Curve, where performance declines in the first couple of years of a fund when fund expenses and investment losses exceed investment gains, but the fund’s performance improves over the next several years.  The J-Curve is more pronounced for early-stage venture capital funds.  The J-Curve looks something like this:

For more on the J-Curve, see my post: “LP Corner: The J-Curve.”
 
The point here is that using absolute returns are really only useful late in a fund’s life or after the fund is liquidated.  If one were to apply a 20% absolute return metric to the fund in the J-Curve example above, the fund would underperform all years until the last year in the graph.

To read more, please click "Read More" to the right below.

Basic Limited Partnership Structure
In a basic limited partnership, there are several passive investors (known as "Limited Partners" or "LPs") and the manager of the fund, (known as the "General Partner" or "GP").  The diagram below illustrates this basic structure.

Private equity funds (buyout, venture capital and growth equity funds) are typically structured as limited partnerships, which have two types of partners: limited partners, or LPs, which are passive investors in the fund; and a general partner, or GP, which is the manager of the fund.  As I evaluate funds, one of the fund terms that receives special attention is the amount of money the GP will commit to the fund - which is called "GP Commitment", "GP Capital Commitment" or "GP Commit."  ​

To read more, please click "Read More" to the lower right.