Introduction to private equity course: fees

Private equity fees

Training course provider: So let’s start at the top; don’t look too much at your pack because it will… it will spoil the surprise. How do the private equity firms make money for themselves? We know what they’re doing – buying low, selling high; I’m going to ask Ollie; how do the private… what’s one of the ways that private equity firms make money for themselves?

Management frees: private equity firms charge annual % fees on funds under management

Delegate: Management fees.

Training course provider: Management fees. So they’re a subset of the funds management industry and they charge an annual fee on the money that they’re managing; much like… have you got a pension fund where you are? Or your own personal pension?

Delegate: Yeah.

Training course provider: And each year they take an annual management charge.

Delegate: Hmm.

Training course provider: And what… do you know what the percentages might be?

Delegate: For private equity?

Training course provider: For private equity perhaps, or well think of it…

Delegate: Two percent

Training course provider: Maybe up to two percent is a very good guess. Maybe up to two percent is a very good guess. So that’s one way that they can… that they make money, they charge a percentage management fee.

Private equity fees

Carried interest: private equity firms retain a share of the profits from the sale of companies they own

Training course provider: David, one other way?

Delegate: Erm…

Training course provider: That you might know about. If you don’t know, that’s fine. No? Matt.

Delegate: Carry on investments.

Training course provider: They have something called “Carry” which is a bonus arrangement. How does Carry work, do you know?

Delegate: The… they get a share of the profits on… on… on winding up the fund.

Training course provider: They get a share on the profits of winding up of the fund. So we… we were looking at a deal that had done quite well, hadn’t it? That we’d invested one hundred; we’d invested at a valuation of one hundred, we’d put twenty in, turned that into sixty – that was a good deal. That was a good deal. I want you to imagine that one, Matt; and maybe you don’t know, maybe you do, but how are the carry arrangements going to work on a fund where we’ve been able to achieve that? Where we… where we’ve been able to achieve a three-times money multiple on our fund, roughly how are the carry arrangements going to work?

Delegate: Is it… is it normally around twenty percent of the profits?

Training course provider: Well I tell you what you do hear about, is you hear about a two and twenty fee arrangement. The two, Ollie, is what you were talking about. The two percent is the annual management charge; but we know that they’re going to get a top slice of the profits; the top slice on the profits of twenty percent – that’s the two and twenty. So on our… on our gain… on our gain the private equity firm is going to get a twenty… a twenty percent bonus. It’s like a bonus.

Delegate: Yeah.

Training course provider: The two percent if you like, Ollie, is like the… is, if you’re thinking about…

Delegate: Running costs.

Training course provider: It’s the running costs of the fund. To use an analogy it’s like a sales person’s base salary – the two percent is their base salary. Their bonus arrangement consists of twenty percent of the upside. The only thing that you probably need to understand beyond that; the only thing you need to understand beyond that…

Delegate: Hurdle rate.

Training course provider: …is… what’s that? Some…

Delegate: A hurdle rate.

Training course provider: A hurdle rate. Something called a hurdle rate. So what this is, is if you like, a minimum return which is negotiated between the private equity firm and its investor base. A minimum return. So they don’t get a straight twenty percent of the gain, they get twenty percent after the fund has generated a minimum return for the private equity investors. Do you know what that might be, Matt? It’s subject to negotiation.

Delegate: Ten.

Training course provider: It might be ten percent.

Delegate: I’d say more.

Training course provider: Might be… might be… may… might be more if the private… if the investors have been able to negotiate that. Or it might be less if the private equity firm’s got a very good track record. Let’s use the figure of ten percent. OK. So on the twenty million that the investors have put in, the first ten percent of the return each year… the first ten percent would go back to the investors.

Delegate: Yeah.

Training course provider: OK. So if we were to prioritise the release of funds, or the distribution back to the investors, the first twenty million – the original investment – goes back to the investors. Then the next ten percent every year, compounded up; the next ten percent in year one, ten percent in year two up until the point we sell, the next ten percent – that next slice – goes back to the investors. What’s left over, if you like, is the notional profit, and eighty percent of that is going to go back to the investors. Eighty percent back to the investors, and the last twenty goes to the private equity firm. And the good news if you’re working in private equity, David, is that twenty… that last twenty percent can be a lot… a large amount of money spread over a few people. The bad news that we know from private equity at the moment is that it’s very hard for them to get their exits.

Carried interest

More private equity training course material

The introduction to private equity course continues by looking at funds’ monitoring and arrangement fees.