Investment costs associated with private equity

I could write a book about the costs that are related to private equity investments.

For now, you’ll have to make do with this article, which is a little bit long, though, because I want you to know all the fundamentals.

In reality, there are as many types of cost structures as there are private equity funds. Nevertheless, I’ll give you an overview of the most commonly used types of expenses and cost structures to be aware of.

Make yourself a cup of coffee and hang on for the ride.

What expenses are associated with investing in private equity?

Let’s start with some basics to make sure we’re on the same page. When you invest in private equity, you commit to investing a specific amount in the fund. You don't pay the amount immediately; instead, you make a commitment.

Your commitment is binding throughout the lifetime of the fund. It means that the fund can "call" money when they need capital to acquire new companies or cover expenses. The part of your commitment that you haven't fulfilled yet is called your unfunded commitment.

If you fail to meet capital calls promptly, the fund can typically demand an interest for the late payment, and if you can’t pay, it could even cost you your share of the fund. Therefore, it’s crucial to be aware of your unfunded commitment at all times and ensure you have the necessary liquidity readiness to meet capital calls from the fund.

Now, let’s talk about the players in private equity. Essentially, there are two sides – a General Partner (GP) and a group of Limited Partners (LPs). The General Partner is the company that created and runs the fund. Limited Partners are the investors (like you) who’ve made a commitment to the fund.

The fundamental costs of investing in private equity, which are pretty standard across most funds, are management fees and performance fees received by the fund's General Partner from investors (Limited Partners) for their work.

Apart from these fundamental costs, many funds also charge various forms of deal fees in connection with their efforts in negotiating purchase agreements with companies they want to invest in. It’s also increasingly common for funds to use so-called equalizations and equalization rates when some investors jump into the fund later than others.

Let’s take a closer look at each type of costs.

Management fee

Management fees cover salaries for the fund's employees as well as other fixed and variable expenses associated with managing the fund.

Typically billed quarterly, the fund's management fee commonly falls within the range of 1.5-2% annually, calculated either on the committed capital or the invested capital (AuM).

Many funds also use a combination of the two fee structures. During the investment period, they may charge a management fee based on the committed capital, and afterward, it may switch to being based on the invested capital for the remainder of the fund's life.

The amount you need to pay in management fees is always specified in your Limited Partner Agreement (LPA).

There is no clear-cut answer to which fee structure is better for management fees, as each approach has its pros and cons. On the one hand, one might argue that it’s preferable to pay as low a management fee as possible and that it would be fairest to pay management fees only on the invested capital throughout the fund's lifespan, not on the committed capital.

However, it's essential to consider that if the fund only receives payment for its work when it begins to invest, it could potentially motivate the fund to rush into deals that may not be ideal. On the other hand, if the fund receives management fees for the committed capital throughout the fund's lifespan (and not just the invested capital), one could argue that they would be more motivated to be careful in entering the best possible agreements. On the flip side, this fee structure could also lead to the fund being slow in starting to invest and generate returns, as it also receives management fees for the period when no investments are made.

Moreover, the total management fee over the fund's lifespan would generally be much higher if you pay for the committed capital rather than the invested capital, as the entire committed amount is typically not invested until after five years. Up to this point, you would, therefore, pay less in management fees if it were based on the invested capital. It's also worth noting that funds often do not call the full 100% of your commitment. This means that you might find yourself paying management fees for a higher amount than the fund will ever manage.

So, there are trade-offs to consider between paying management fees on the invested capital or committed capital throughout the fund's lifespan. One could argue that a combination of both – paying fees on the committed capital during the investment period and then on the invested capital for the rest of the fund's lifespan – is the fee structure that best aligns the interests of the fund and investors. However, as an investor, it’s ultimately up to you to weigh the pros and cons and decide which structure suits you best.

One could argue that a combination of both – paying fees on the committed capital during the investment period and then on the invested capital for the rest of the fund's lifespan – is the fee structure that best aligns the interests of the fund and investors.

Carried interest (carry or performance fee)

On top of the management fee, most private equity firms (General Partners) tack on a performance fee of approximately 20%, often referred to as carried interest or carry. They levy this fee if the fund achieves a return that surpasses a minimum threshold, also known as a hurdle rate.

The hurdle rate is predetermined and typically stands at 8% annually. However, due to the increasing interest in private equity, there’s been a trend towards using a lower hurdle rate. Some funds have even eliminated the hurdle rate entirely.

The hurdle rate serves two purposes. One is to ensure you, as an investor, a minimum return on your investment. The other is to ensure that the fund takes on sufficient risk to generate a satisfactory outcome.

In this context, it's worth noting that venture funds often argue that they don't need a hurdle rate, given their fund type, which naturally involves a relatively high level of risk. However, it's crucial to remember that the hurdle rate also functions to secure you a minimum return.

Soft hurdle rate and hard hurdle rate

When discussing hurdle rates, there's a broad distinction between a soft and a hard hurdle rate.

With a soft hurdle rate and a 20% carry, the General Partner (GP) typically takes 20% of the fund's total returns once it surpasses the hurdle rate. This means that investors (Limited Partners, LPs) would actually gain more from their investment if the fund achieves an 8% return than a 9% return. This is because the LPs receive the entire return with an 8% return whereas the GP receives 20% of a 9% return. That is, in the case of a 9% return, only 7.2 percentage points go to LPs whereas 1.8 percentage points go to the GP (see table below).

Soft hurdle rates usually involve a 50-100% catch-up mechanism. As the name implies, it’s a mechanism that determines how GP catches up with the LPs with regards to the return they get. A 100% catch-up means that investors receive the full return up to the defined hurdle rate. The GP then takes the full return of the following gains until they reach the portion equivalent to the agreed-upon carry. In case of a carry of 20%, GP will take the full return until reaching an 80/20 distribution of the total return achieved by the fund. Additional returns are distributed 80/20 between GP and LPs.

In a 50% catch-up scenario, investors get the full return up to the hurdle rate, after which the GP receives 50% of the excess return until they reach the carry portion of the total return. This mechanism ensures that your return cannot fall below the hurdle rate once the total return has exceeded it, as it can with a soft hurdle rate with no catch-up mechanism (see table below). The GP receiving their carry cannot lead to your return dropping below the hurdle rate.

With a hard hurdle rate, investors get a larger portion of the return, as the GP's carry is only 20% of the return portion above the specified hurdle rate and not the total return achieved by the fund. This is also known as operating with a true preferred return for LPs and is generally the most favorable hurdle rate structure for you as an investor.

The table below provides an overview of how different hurdle rate structures impact your returns.

Deal fees and other deal-related costs

Many funds also tack on deal fees for the additional work related to negotiating acquisition and investment agreements with the companies they want to invest in. Some funds offset deal fees against the management fee, but more often than not, deal fees are an additional expense chipping away at the fund's capital for investment.

Deal fees typically range from 2-4% of the transaction value and are levied when the deal is closed or if it falls through since there are also costs associated with deals that don't pan out for various reasons.

The question of whether deal fees are positive or negative for you as an investor can be debated. On one hand, they might be seen as a motivator for the fund to do what it takes to close a deal. On the other hand, there's a discussion about whether it could incentivize the fund to enter agreements just to snag those fees. However, the prospect of carried interest with high performance should be a more significant motivational factor than deal fees.

Besides deal fees, there are often other costs tied to the fund's efforts to invest in companies. These could include expenses for third parties such as lawyers and auditors, and these costs are typically unavoidable.

Equalizations and equalization interest

In the scenario of some investors joining a fund later than others, an increasing number of funds have started using what is referred to as equalizations. Equalizations represent the capital flows designed to ensure that all investors have contributed an equal share of their commitment to investments, management fees, etc., even if they entered the fund at different times. This is because new investors also acquire a stake in the fund's existing investments.

When an investor enters a fund later than others, it can also incur costs in the form of equalization interest, a practice adopted by more and more funds.

An equalization interest is an interest rate that new investors, through the fund, pay to the original investors to compensate them for the fact that the new investors now share in the fund's investments. In simple terms, the original investors have essentially 'lent' the new investors the portion of the fund's capital that the new investors would have contributed to the fund if they had been part of it from the beginning. Therefore, the new investors are paying the original investors interest on this 'loan'.

Equalizations represent the capital flows designed to ensure that all investors have contributed an equal share of their commitment to investments, management fees, etc., even if they entered the fund at different times.

You might be curious about the magnitude of this interest. It varies from fund to fund, but it is often set to be the same as the fund's hurdle rate.

The fund aims to strike a balance with the interest rate, avoiding setting it so high that it scares off potential new investors. Simultaneously, the original investors want to be fairly compensated for new investors sharing in their returns. Since the hurdle rate represents the minimum return an investor expects from their investment, it makes sense to use it as a reference point when determining an equalization interest.

The calculations underlying the amounts called for equalizations and equalization interest can be highly complex, especially if the fund has already cashed in on some investments when new investors join. Consequently, funds themselves sometimes make errors in their calculations. It’s crucial for you to double-check and make sure you’re not paying more than necessary.

How do you keep an overview of your private equity investments?

There is no common standard among private equity funds regarding the calculation and reporting of costs and results. For instance, some funds deduct management fees, while others deduct other expenses and interest in their return calculations. This can make the return appear higher than it actually is in relation to your total payments to the fund.

At Aleta, we have extensive experience in private equity reporting. This means we have a good understanding of most funds and their reporting practices. We use this knowledge to provide you with an accurate overview of the funds' returns – for example, by including management fees and other costs in our calculations.

By applying the same method for calculating returns across all funds, we enable you to compare the results of different funds. This way, you’re better equipped to make informed decisions about your investments.

Drop a line if you have any questions about our private equity reporting or about the article.

By applying the same method for calculating returns across all funds, we enable you to compare the results of different funds. This way, you’re better equipped to make informed decisions about your investments.