Catch 2-and-20

Two separate pieces of research, when brought together, reveal that a long-standing problem in the LP-GP relationship remains front of mind when the two sides meet at the negotiating table: how to compensate fund managers in a way that effectively aligns their interests with investors.

The first piece of research revealed that around 80 percent of LPs now feel that the traditional 2 percent management fee is no longer acceptable in the current climate. Of course GPs have long known that the classic 2-and-20 management fee and carry model is becoming less and less common, but a smaller percentage (38 percent) of investors said even GPs with an impeccable track record are no longer immune to this pressure. Clearly a significant percentage of investors feel that management fees are – in some cases – providing GPs a stable, continual source of revenue regardless of fund performance and may be creating incentives for managers to keep raising larger funds.

Some GPs, in response to this concern, now offer a menu of different carry and fee arrangements that provide investors reduced fees in return for a greater slice of profits. Another interesting solution one LP had shared with PE Manager is tethering carry to performance. This investor would be willing to pay a 30 percent carried interest share for any return over 2x. Anything under 2x and the GP receives 10 percent. Since most GPs are (outwardly) confident that they will return to LPs two times their money (since the majority of GPs are top quartile), it’s ostensibly an offer to which they should have a hard time saying no.

But before LPs rush out to bargain for a squeezed ‘2’ and higher ‘20’ in fund documents, a second piece of research suggests the promise of lucrative carried interest payouts may be its own conflict of interest. Because the size of the GP's return goes up substantially during the period immediately after hitting an agreed hurdle rate, managers are financially incentivised to push through exits to lock in returns – even if holding onto investments for a longer period might generate a better return for LPs over the life of the fund. More promise of carry (and the need to find alternative sources of revenue in response to lower fees) would only exacerbate the issue.

Unfortunately no easy solution exists to the problem of 2-and-20. But LPs and GPs can do what they’ve always done: negotiate fund terms with an understanding that relationships in this industry are built on trust and communication. Research into compensation arrangements will hopefully only steer LP and GP conversations along.