James Gelfer August 28, 2013
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Unlike a traditional business, which has well-defined streams of cash flow, private equity (PE) firms possess a diversified business model with several discrete investments. Due to this unique structure, gauging the profitability and success of a firm and its partners can be a challenge.
PE firms often have billions of dollars in assets under management, but the vast majority of these funds will be utilized exclusively for direct investment in portfolio companies. Which begs the question, how do PE firms make money? There are really just two main ways:
There are two ways PE firms make money: through fees and carried interest.
The first (and most reliable) method for a PE firm to generate revenue is through fees. Fees are utilized to fund the daily operations of a PE firm, including overhead costs and salaries. Through the years, firms have become quite adept at identifying opportunities to extract fees. First, all LPs have to pay a management fee—usually 2% of committed capital—for the privilege of investing with a private equity firm. Recent reports have highlighted how many firms waive the fee and have it directly invested into the fund, which allows general partners to realize revenue at the capital-gains tax rate.
Aside from charging their investors, PE firms also generate capital from their portfolio companies. During the initial deal, the firm takes a transaction fee of around 1% of the deal amount. Furthermore, the PE firm charges portfolio companies monitoring fees for various consulting and advisory services performed during the life of the investment.
For more on PE deal terms, read PitchBook’s latest PE Deal Multiples and Trends Report here.
While fees may keep the lights on, carried interest is where PE firms and their limited partners make the real money. Carried interest refers to the private equity firm’s share of the capital gains generated by a fund, which are created by earning profits on portfolio investments. Firms typically realize returns on their investments by selling the company or taking it public, but another option is a dividend recapitalization.
Most PE firms are eligible to receive 20% of the carried interest according to their limited partnerships. However, firms must achieve a predetermined rate of return (referred to as the hurdle rate and typically set at about 8%) before taking part in carried interest to ensure investors receive an adequate return. The best performing PE firms are often able to command more than 20% in carried interest and negotiate a low hurdle rate—or none at all.