Private Equity Fees
Private Equity firms with committed capital have a pool of limited partners who invest in a fund controlled by the private equity management team (the general partner). The private equity firm (the GP) is compensated through a management fee plus a performance fee. This arrangement is often called the “2 and 20” fee schedule, as discussed below.
Management fees are usually ~2% of either committed capital of invested capital.
Some firms charge the management fee on the entire committed capital while other firms only charge the management fee on invested capital. The second approach often results in a lower management fee.
The performance fee is often 15% – 20% of the increase in value upon exit from the portfolio companies.
The performance fee is often called carried interest, or just “carry” for short. Some private equity funds have a required rate of return that they must exceed before the carried interest is paid. This rate is called the hurdle rate. The hurdle rate (often 5% to 8% return) prevents the private equity firm from being compensated on organic inflation and incentivizes the PE management team to outperform standard benchmarks that the LPs could have achieved by just investing in a broad market index fund.
In addition, some private equity firms charge their funds an administration fee to cover costs associated with accounting, audit and legal expenses.
The combination of the management fee and the administrative fee serve to ensure that the private equity management team covers its base costs. However, the real opportunity to create wealth is in the carried interest.