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Fees that ignore performance
Two and twenty
The standard deal is two and twenty: 2 percent a year on assets under management, plus 20 percent of the upside. The 2 percent has nothing to do with performance, and it grows with the size of the fund. A manager with a $100 million fund has a reason to raise $400 million next, then $1 billion, then $2 billion, then $5 billion.
A different structure
Permanent Equity, a firm founded by Brent Beshore, took a different structure: no fees of any kind, no reimbursements, and no cash from investors or portfolio companies. The firm takes a percentage of free cash flow as it is returned to investors. It is called beer money, meaning cash you could buy beer with. That percentage is well above 20 percent, because there is no 2 percent alongside it.
The comparison
The comparison comes down to total return on capital and who gets to keep what. Depending on how it is calculated, 30, 40, even 50 percent of private equity returns can go to the manager. One industry tally counts 106 types of fees in private equity, and Permanent Equity charges one of them.
Why do fees grow with fund size?
Management fees are charged as a percentage of the money a fund manages, so a larger fund pays its manager more every year no matter what the investments return. A manager who raises a fund four times larger collects four times the fee income at the same rate. At a 2 percent rate, each additional billion dollars raised adds 20 million dollars in annual fees.
Where did two and twenty come from?
The 20 percent share of profits is called carried interest, and its roots are often traced to merchant ventures in which a ship's captain kept a share of the gains. In 1949, Alfred Winslow Jones started a fund often described as the first hedge fund, which charged investors 20 percent of profits. Hedge funds and private equity later paired that profit share with a flat management fee. The combination became so common that it took the nickname two and twenty.
How do hurdle rates limit the profit share?
Many private equity funds include a preferred return, also called a hurdle rate, which investors must receive before the manager earns any profit share. A commonly used figure is 8 percent a year. Many agreements also include a catch-up provision that lets the manager take a larger share of profits once the hurdle is cleared. These terms are written into the fund's limited partnership agreement.
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