How Profits Are Distributed for a Private Equity Fund

There are a number of different methods of calculating private equity fees for general (fund manager) and limited partners (investors).  These terms are spelled out in the limited partnership agreement.  The purpose of the fee structure is to align the interests of the investors and fund manager in order to obtain the best returns possible.  The most important fees are the management fees and carried interest.  Management fees are between 1%-2.5% of committed capital.  Carried interest is usually about 20% of profits.

Profits for a fund can be based on an aggregate level or individual transactions.  For the investor, it is best if the aggregate calculation is used.  For the manager, it is best if profits are based on an individual investment basis.  The manager shares in the profits as soon as the IPO or other exit strategy is done.  This approach may cause the manager to exit his investment prematurely, before its full value is realized.

To earn the carried interest, the manager has to hit a target return rate.  The average rate is 8%.  They are usually 5%-10% and tied to the risk-free rate.  The hurdle rate is applied to buyout and European venture capital funds.  There are two types:  hard and soft.  The hard rate allows the manager to share in the profits above the hurdle rate.  This is used in European funds.  US funds are more likely to use the soft rate calculation which allows the manager to share in all the profits.  The distribution of the fund's proceeds follow this pattern:

• Investors' capital is returned
• Investors' profits are paid up to the hurdle rate
• Fund manager's profits are paid up to the hurdle rate
• Any profits above the hurdle rate are split between investors and manager according to the limited partner agreement

An additional clause to protect the investor called a clawback can be added to the limited partner agreement.  It ensures that the investor receives, at least, the hurdle rate return.  The manager must return any incentive fees to the limited partners.  However, the effectiveness of the clawback is dependent on the ability of the manager to re-pay the money owed.  The investors can have some of the carried interest placed in an escrow account to cover any possible clawback.

Unlike hedge funds, private equity fees are paid out as profits are realized.  Hedge funds are paid out based on the current market value of the portfolio.

The information above is a summary of a paper written by Didier Guennoc, Pierre-Yves Mathonet and Thomas Meyer called Distribution Waterfall and is part of the CAIA curriculum.