High fees aligned with performance incentives

Fund managers in private markets get paid in two ways: through annual management fees to do all due diligence, sourcing and daily management, and through profit-sharing arrangements to incentive good performance, in alignment with fund investors.

Private equity (like most other private markets strategies) is an active management investment strategy, therefore investors can end up paying a higher fee when performance is good compared to passive public markets strategies found in mutual funds. In mutual funds, investors pay an annual fee on asset value regardless of the performance of the investment. In private equity, investors pay subject to the performance of the fund: lower fees if performance is below targeted returns, and higher fees if performance is above.

Management fees

Management fees cover the ongoing operational expenses of running the fund such as salaries, office space, technology and “dead deal” due diligence costs. These fees are typically calculated as a percentage of the assets managed by the fund ranging between 1% and 2% depending on the type of strategy, and are paid annually by investors to the PE manager.

Example: You invest €100,000 in a fund charging a 2% management fee which results in the manager collecting €2,000 in management fees from you annually. These fees are paid out of your investment and are not invoiced to you for out-of-pocket payment.

Carried interest

Carried interest refers to the profit-sharing agreement that aligns investors and fund managers. These are performance fees that incentivize fund managers to deliver returns to investors that are greater than a pre-determined hurdle rate. These fees are typically structured so that fund managers keep 20% of all profits generated if they deliver at least an 8% net annual return to investors (net of management fees paid). Like management fees, this structure can range depending on the strategy, usually from 10% to 20% of profits and hurdle rates of 6% to 8%.

‍Carried interest is only paid by investors if the fund manager successfully invests and divests a profit-generating investment.

Example: The same manager charges a 20% carried interest above an 8% net annual return hurdle rate. After one year the fund generates a 15% net return surpassing the 8% net hurdle rate, generating a profit of €15,000 on your €100,000 investment. The manager is entitled to 20% of profits generated above the 8% net hurdle rate, thus collecting €1,400 in performance fees.

Before receiving any carried interest, fund managers have to return the entirety of the invested capital (including the management fees charged to investors) and the hurdle rate return to investors.

The industry-wide expression “2 & 20” refers to the market standard for private equity funds charging a 2% management fee and 20% performance fee to investors.

Bottom line

1. Management fees allows them to run their daily operations and investment activities. These fees are usually returned to investors if the investments the fund manager makes turn out to be profit-generating for end investors.

2. Carried interest is the profit-sharing agreement between investors and fund managers that creates an alignment of interests and incentives fund managers to generate outsized profits for investors.

3. Private equity is an active investment management strategy meaning fund managers are heavily involved in daily operations of their investments and usually drive the most relevant strategic decision-making. This results in private equity being more expensive for investors than other passive public markets investment strategies, however, only if fund managers generate outsized returns to its investors.