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By Manu Midha Abstract: The article defines various components of the total compensation of General Partners in a VC / PE setup (which could be a partnership or a private limited concern). It talks about some of the recent trends in the industry and what determines the exact compensation structure. The article may reflect some of the biases held by the author, and one is free to agree/disagree. Comments and suggestions are welcome. No character/fact in this note is fictitious. Definitions GP - General Partners of a PE/VC fund are the managers of the investing entity. They are the ones who raise capital, identify and evaluate investment opportunities, make investments and finally exit them and return the capital back to the investors. Most of them also co-invest with the LP’s in the fund, but normally their investments are limited to around 5% of the total size of the fund. LP - Limited partner of the PE/VC fund, the investors to the PE fund. These are called ‘Limited’, as their roles are limited to making investment to the fund and not in the general management of the fund. They typically meet at periodic intervals to monitor and discuss investments made by the fund. Illustration: For the purpose of this note, we will assume a WIMWI PE fund, of 10 year life and size $1Billion, managed by a team of GPs headed by ‘Maacho’ ji, and invested into by a team of LP’s represented by ‘Nacho’ ji (doesn’t he look like one?, believe me he has a big portfolio!!).
General Partners [The PE Firm] (Partnership/Pvt. Ltd. Co)
Limited Partner (Eg. Pension Fund)
Limited Partner (Eg. Univ. Endow.)
Limited Partner (Eg. Fund of funds)
Manage and Co-Invest ($$)
PE/ VC Fund (The WIMWI PE Fund)
Receive Investments ($$) ($$) ($$) ($$)
Portfolio Company 1
In our Current Illustration: GPs represented by ‘Maacho’ji LPs represented by ‘Nacho’ji
Figure 1: Structure of a typical PE / VC Fund
Introduction Executive compensation has been a topic for much debate off late. There have been several reports published on compensation of executives working with banks and other financial institutions. Not much has really been said about compensation of General partners in Private equity (and Venture Capital) firms. This is not really because they are less paid than the former or because most of this industry (PE/VC) moves with a lag to the actual financial markets, but because there were fewer funds being raised and new compensation plans being published off late.
Demystifying Compensation of GP’s There are three basic ways in which General Partners are compensated. These are: 1. The fund management fee: Also called Management fee, this is an annual fee and is normally a fixed percentage of the total capital committed during the investment period and sometimes a fixed percentage of unrecovered capital thereafter. Committed capital is the amount of money that the LP’s have paid cumulatively upto that point. The industry standard is about 2% for Venture funds (smaller) and about 1% for larger PE funds. Unrecovered capital is the part of the fund that is not paid by the LP’s as yet. Not all money is paid upfront by LP’s but is paid in installments. Illustration 1: Say for our WIMWI Fund the LP’s, led by ‘Nacho’ji, have committed to pay $ 1 Billion over 5 equal installments in 5 years (4 – 5 installments is the norm) i.e. $ 200 million per installment. Let us also assume a 2% fund management fee to be paid to ‘Maacho’ji and group. Therefore, for the first year the Fund management fee amounts to $4 million (2% of $200 million) for the second year it would be $ 8 million and $ 12 million for the third year and so on till it reaches $ 20 million in year 5. (Remember fund management fee is a percentage of the cumulative capital paid by LP’s). Now after year 5, it stays constant at $ 20 million per year for the last 5 years. This fee is normally used to cover the fixed expenses of the fund, eg. salaries, office rent, etc. Exceptions from the illustration: This may be calculated annually / semi-annually or quarterly based on the pay-in structure of the fund.
This fee is often reduced after the fund’s investment period (normally the first 5 years) equally over the last five years. 2. Carry: Carry or carried interest as it is called, is the share of the capital gains that a private equity partnership (or company) earns from its investments. Upon successful exit or upon maturity of the fund, the estimated profit on the investment is calculated and is distributed in a pre-determined ratio. Industry standard for this share is 20%, i.e. after paying off the LP’s their committed capital (principal) the gains are divided in the ratio of 80 – 20 and are distributed to the LP’s and GP’s respectively. Illustration 2: Say in our own $ 1 Billion WIMWI fund, upon all successful exists after the 10th year the fund fetches an exit value of $ 2 Billion. This means capital gains of $ 1 Billion over the base investments. Assuming the industry standard payout for Carry (80/20), ‘Maacho’ji and group would receive $ 200 million as the Carry, from the fund. While ‘Nacho’ji would receive $800 million as profit on his $ 1 Billion investment. This was the most basic way though and there are a number of ways in which this carried interest is distributed, with respect to timing and magnitude. The concept of Preferred return There is a concept of preferred return, or commonly called as the huddle rate, wherein over and above what the LP’s have initially invested (their Principal) they expect a basic return (huddle rate) to be paid to them upon maturity of the fund, before the profits are divided between them and the GP’s as per the pre-specified ratio. Illustration 3: Say if for example in WIMWI fund, the LP’s (‘Nacho’ji) had demanded a preferred return of 10% over the life of the fund.
In this case based on the pay-in structure of the fund ($ 200 million over 5 years) the breakeven for the fund after 10 years is not $ 1 Billion but $ 2.16 Billion. Therefore even though ‘Maacho’ji and group earned $ 2 Billion at exit they are not entitled to any carry based on these terms. Only when the exit value would have been above this threshold, carried interest would be distributed as 80% to Nachoji and 20% to Maachoji. 3. Professional service fee: GP’s are known to provide a host of services to their portfolio companies. Services may include investment banking services, monitoring of the company, consulting in niche areas, debt raising, etc. For all these services, the GP’s normally charge their portfolio companies service fee which is also sometimes called Transaction fees. There has been a lot of debate on the topic of whether GP’s like ‘Maacho’ji and group should be taking fee from their own portfolio companies (it’s like charging your wife for help at home). To make the incentives aligned, many a time the Fund contract makes it mandatory to set off 50% of the professional fee gained from these services against the Management fee of the Fund managers. This means that only 50% of the fee is given out to the GP’s while the rest is treated as an income of the fund, and would accrue to the investors (LP’s). My Two Cents: The issue of percentage of carry vs. management fee is a subject of huge debate. For a fund, both these are marketing variables to play with when they are trying to raise a new fund. Big and respected GPs like ‘Maacho’ji, or the Blackstones and KKRs of the world who have relatively stable sources of funding, do not compromise on either of them. While smaller funds in difficult times like these, might lower the management fee or carry or both to attract investors. Having said that, for investors or LP’s the issue of fee is secondary and comes in to make close choices between very funds with similar past performances, etc. Further increasing carry at the expense of management fee sometimes shows confidence of GPs on their investment philosophy and may attract investors.
Variations are also expected in the percentage of management fee across the size of funds, and larger funds would have a lower management fee than smaller funds, as they reflect fixed cost of operations of the General partnership. Therefore even though a fund may be large in value, but it may not be proportionately larger in the management team size, etc. Recent trends in the industry show that few VC firms have lowered their management fee as investor funds are hard to come by. References: Few relevant pdf’s/links/articles which could be looked up for further information on this topic: 1.http://www.pehub.com/wordpress/wp-content/uploads//watson-wyatt_private-equity-feesand-terms.pdf
2. http://deals.venturebeat.com/2009/08/31/is-it-time-for-the-venture-capital-two-and-twenty-to-end/ 3. http://mstblog.ohsu.edu/?p=747
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