When it comes to fees in Private Equity, these are the two most common opinions:
The first, and most common among mainstream media, is that the fees are egregious. And despite sky-high fees, asset managers don’t care about performance, pay little-to-no taxes, and are wrecking the companies they acquire.
The second usually involves an explanation for the fees, and how they align the interests of asset managers (GPs) and their investors (LPs).
The 2% fee for assets under management
Funds commonly charge a 2% annual fee for assets under management.
I think a number of firms today secretly view the 2% management fee as an additional profit center. In the land of multi-billion dollar funds, management fees can amount to tens or hundreds of millions of dollars annually.
The 20% performance fee on profits
Funds commonly charge a performance fee of 20% of any profits, also called a 20% “carry.”
Let’s start with a quick history lesson of where the concept originated.
The term “carry” likely originated from the European shipping industry in the 17th century. In those days, captains and their crews were tasked to sail to the Americas or Asia to pick-up goods and return them home. For this dangerous work, they were offered a “carry fee” that was equal to the value of 20% of the goods safely returned. In the context of risking your life for a dangerous task, a fee of 20% seems reasonable.
But is a 20% fee on profits in private equity reasonable? That’s up for debate.
Are the 2 and 20 fees in private equity worth it?
Now that we’ve got the basics of the 2 and 20 covered, how do you know you’re actually getting a good deal? Here are a couple key questions to ask:
- Is this asset manager consistently outperforming the benchmark net of their fees?
- Are they using these fees to generate outperformance?
If the asset manager is outperforming others net of fees, then ask yourself: Why are you so worried about fees?
Take Renaissance Technologies, for example. They charge a 4% management fee and 44% carry — Yes, you read that correctly. They take 44% of all profits, and you pay them 4% every year for management (source: Bloomberg).
But their returns are stellar, and have been for decades — so for that kind of performance, investors are willing to pay such high fees.
Of course, the opposite end of the spectrum from the multi-billion dollar funds are the start-up funds trying to raise their first $50.
So, which fund manager do you decide to fork over your money to in hopes of gaining sky-high returns?
Like most things in life, it’s not a black and white answer: It all depends. As you speak to asset managers and learn about their track record (or the future of their first fund) the answers should become more clear. You either entrust them with your money, or ask them to walk the plank.