Fees trump carry in GP compensation

Management fees more than triple what GPs earn from performance-based carried interest, according to research exclusive to sister site PEM which could fuel the industry’s debate over private equity fee structures.

Late last year Carlyle Group co-founder David Rubenstein reportedly posed a simple question to an audience of private equity professionals: what other industry charges the same fees for funds of different strength and quality?

His question underscored the growing tension felt by GPs and LPs over fund terms and conditions in recent years. As the world crawled out of economic malaise and back into investment mode LPs made clear they would no longer accept uniform charges across funds of varying performance.

There is a risk a GP will be more concerned about their ability to raise a next fund instead of maximising returns for their current investors

Bernd Kreuter

New Jersey’s pension system is one of many prominent LPs to exemplify investors’ stronger negotiating position. The $71 billion pension earlier this year won fee cuts and expense reductions from a number of its alternative investment managers, which will save at least $40 million over the next five years. Likewise, the California Public Employees’ Retirement System, a pacesetter for institutional investors, recently won fee concessions from CIM Group and Apollo Management which together will save the pension $175 million in costs over a similar time period. 

The crux of the issue is that a misalignment of interests can occur between managers and investors when a substantial portion of a fund’s income is derived from management fees, says Bernd Kreuter, head of alternatives at Feri Institutional Advisors. The concern is an annual fee charge independent of investment performance can significantly outweigh the rewards offered by carried interest payments which are determined by the GPs ability to produce capital gains and thus maximise portfolio returns. “There is a risk a GP will be more concerned about their ability to raise a next fund instead of maximising returns for their current investors,” explains Kreuter in an interview.

In research exclusive to sister site PE Manager, private equity scholar Oliver Gottschalg alongside Kreuter discovered management fees do in fact account for a significant portion of GPs total compensation. On average, GPs pocket more than three times as much in management fees than from carried interest, according to the research. The findings are likely to further fuel the industry’s debate over the traditional “2 and 20” rule providing managers 2 percent in management fees and 20 percent in carry.


The research examined a universe of 240 private equity funds raised between 1995 and 2004. Using Preqin data, each funds cash flows were monitored until late last year. A traditional fee structure was assumed to derive the figures while a 2004 cut-off vintage was selected to provide GPs several years to begin divestments.  

The study showed 8.4 percent of an average fund’s committed capital went to management fees, while 2.5 percent was ultimately paid out as carried interest. Sample funds with less than $250 million in committed capital and funds between $600 million to $1.5 billion in capital showed carried interest accounting for a slightly larger percentage of total compensation.

The findings come at a time when LPs have become particularly sensitive to management fees as a result of GPs recent lack of activity, says Gottschalg, a professor at the HEC School of Management in Paris. Many firms’ investment and realisation totals have dropped due to unstable market conditions, putting a wet blanket on the returns hoped for during the industry’s golden years.

In response investors are ramping up their due diligence process of fund managers. “More LPs are asking for a firm’s budget or projection of future operational expenses,” says Bela Schwartz, chief financial officer of The Riverside Company. The conversation typically includes a break-down of fees per employee or transaction, he adds. “Not to compare us with other firms but to verify our staff levels and deal flow justify our agreed management fees.”

Meet me in the middle

On the other hand, one question LPs need to ask is: “How much compensation should the owners of a private equity firm make per year to run a business in the financial services industry?” says Schwartz.

Private equity firms of all sizes face immense pressure to recruit and retain junior talent at a time when carried interest prospects are a fraction of better years, sources say. Careers in investment banking or analytical roles demand similar talent but can promise greater compensation in the short-term through bonuses and other incentive arrangements. 

LPs need to ask how much compensation should the owners of a private equity firm make per year to run a business in the financial services industry

Bela Schwartz

Moreover, both small and large firms in interviews with PEM make the case management fees are not generally exorbitant. They stress a number of firms deviate from the standard 2 percent market rate and fees typically step down at the conclusion of a fund’s investment period.

Mid-market houses in particular are taking fees out of much smaller funds, stress market sources. And in many cases the management fee is not enough to support the larger deal teams employed by small or mid-market firms, says Dante Leone, a private equity lawyer at Capolino-Perlingieri & Leone.

Larger private equity firms justify fee expenses by pointing to their global operations and need to recruit top-tier talent. The ability to source deals across the world requires an office presence in different geographies which in turn requires back-office support and competent managers with experience in the region. Brand name firms have also made the case their exceptional performance justifies a premium to standard market-rate fees. 

The Institutional Limited Partners Association (ILPA), an industry group for private equity investors, argues “management fees should be based on reasonable operating expenses and reasonable salaries, as excessive fees create misalignment of interest”.

In response sources say the debate isn’t around management fees per se, but around a fund’s overall terms and conditions. While some GPs with a lacklustre track record or firms raising multibillion mega-funds are comfortable negotiating lower fees, the majority of funds primarily make concessions on things like deal fees or how carry is paid, says Nigel Hatfield a partner in Clifford Chance’s private funds group. “Many managers are simply unable to afford operating under lower management fees. Instead they entice investors by providing 100 percent of transaction (deal) fees to the benefit of the fund or perhaps move towards a waterfall carried interest model”.

Consequently limited partners have won the most concessions from fund managers on transaction and monitoring fees, according to recent research from SJ Berwin’s in-house database of funds seen by PEM.

The percentage of GPs providing 100 percent of deal fees to the benefit of the fund – in accordance with guidelines published by ILPA– has risen for the fourth consecutive year to 58 percent. This compares with 45 percent of funds in 2009, 38 percent of funds in 2008 and 30 percent of funds in 2007.

The SJ Berwin data also shows some movement towards a European-style waterfall distribution model of returning all capital and a preferred return before distributing any carry. This is in contrast to a US-style of distribution where carry is calculated on a deal-by-deal basis.

Investors' next important battleground is becoming termination rights

Dermot Crean, a managing partner with placement agent Acanthus Advisers supports the notion LPs are choosing their battles around periphery conditions. Investors' next important battleground is becoming termination rights, says Crean. “LPs want new protections after experiencing everything going wrong during the downturn.”

Whether terms and conditions will be renegotiated once the market cycle circles back in favour of GPs remains to be seen. In any case PE Manager will be sure to keep you posted.