PE Funds: Economics
Key Economic Considerations When Investing in a Private Equity Fund
This post is part of a four-part series exploring key factors to consider when investing in a private equity fund. In this installment, we focus on economic considerations, while subsequent posts will address governance, the stages of a fund’s lifecycle, and liabilities.
Investing in a private equity fund offers significant opportunities for portfolio diversification and long-term growth. However, these opportunities come with unique economic factors that investors must evaluate carefully. Below, we highlight five critical financial aspects that potential investors should understand before committing capital.
1. GP Commitment
The General Partner (GP) commitment refers to the portion of the fund's capital invested by the General Partners themselves. This alignment mechanism ensures the GP's financial interests are closely tied to the fund’s performance.
Amount: Investors should assess the GP’s commitment relative to the fund's overall size. A substantial commitment signals the GP’s confidence in the fund’s potential.
Contributors: The GP commitment should come from the fund’s principals, not third parties (e.g., friends, family, or external investors). This ensures that those responsible for investment decisions have a personal financial stake in the fund’s success.
2. Management Fees
Management fees are a primary income source for the GP and are charged to cover operational costs. These fees vary depending on the stage of the fund’s lifecycle:
During the Investment Period: Management fees typically range from 1.5% to 2% of the total committed capital. These fees support the GP’s efforts to identify, evaluate, and acquire investments.
Post-Investment Period: After the investment period, fees are generally based on 1.5%-2% of the invested capital, taking into account any investments that have been sold or impaired. This step-down aligns the GP’s incentives with the performance of the fund’s investments over time.
Credit funds often do not have a fee step-down, as fees are based on the fund’s invested capital throughout its life.
3. Investor Expenses
Private equity funds typically allocate certain expenses to the fund, which investors ultimately bear. Understanding these costs is crucial for evaluating the net return on investment.
Organizational Expenses: These cover legal, accounting, and setup costs incurred during the fund’s formation. Investors should ensure these expenses do not include the organization of the General Partner and avoid paying placement fees, which is not standard practice. However, upfront placement fees can be paid by the fund, provided there’s a mechanism for reducing management fees over time to offset these costs.
Regular Partnership Expenses: Funds typically cover their own operational expenses. The fund’s documents will list these expenses, providing a safe harbor for sponsors to allocate costs to the fund. Investors should review these expenses carefully, ensuring that costs are appropriately assigned and not unfairly shifted to the fund.
4. Fee Leakage
Transaction fees, earned by the GP for services like advisory, monitoring, or investment banking, must be carefully evaluated by investors.
Offset Mechanism: It is market standard for transaction fees to be offset against management fees. This means the transaction fees earned by the GP reduce the management fees charged to investors, preventing “double-dipping,” where the GP benefits from fees both from the fund and from transactions below the fund.
Transparency: The fund’s documentation should clearly disclose how these fees are calculated and how they offset management fees to ensure transparency and fairness.
5. Carried Interest
Carried interest represents the portion of the fund’s profits allocated to the GP, typically serving as an incentive for strong performance. Key considerations include:
Calculation Methodology: Carried interest can be calculated either on a deal-by-deal basis or at the fund level:
Deal-by-Deal Waterfall: Carried interest is distributed after each successful investment exit. While this method can reward the GP earlier, it may create misalignment if early gains are not sustained across the fund’s lifespan. Some investors may negotiate an escrow or holdback mechanism, ensuring the GP doesn’t receive carry if, after distribution, the value of the remaining investments (assuming they are liquidated) would prevent them from earning carry.
Whole Fund Waterfall: Carried interest is distributed only after the fund achieves a predefined return threshold across all investments. This approach better aligns the GP’s incentives with the overall fund’s performance.
Hurdle Rate: Most funds set a hurdle rate—a minimum return that must be achieved before the GP is entitled to carried interest. This rate typically ranges from 6% to 8% annually and serves as a benchmark for evaluating fund performance.
Credit funds generally split carried interest between current income and principal repayment, reflecting the nature of credit investments, which often derive returns from both ongoing cash flows (e.g., interest payments) and the eventual repayment of principal.
Conclusion
Investing in a private equity fund requires navigating complex financial structures and economic arrangements. Thorough due diligence on the GP commitment, management fees, expense allocation, transaction fees, and carried interest terms is essential to ensure alignment with your financial goals and risk tolerance.
