Study: ‘2 and 20’ holds steady

Despite the perception that investors have increased their bargaining power at the negotiation table, basic fund terms have remained surprisingly constant, according to a study from German academics.

“The Evolution of Private Equity Fund Terms Beyond 2 and 20” found LPs have only managed to negotiate more favorable waterfall distributions and rebates on portfolio company fees. The new norm is for funds to distribute carry based on performance of the entire fund (and not under the more US-centric deal-by-deal model) and for 100 percent of fees charged to portfolio companies to be collected at the fund-level (and not split with the GP management firm).

Only GPs that try and raise a large successor fund tend to experience a dip in management fees, Technische Universität München research associate Ingo Stoff, one of the study’s authors, told PE Manager. A 100 percent increase in fund size correlates to a 0.16 drop in the management fee (so a standard 2 percent fee becomes 1.84 percent), according to the study.

The study also highlights the risk that larger funds can distort a GP’s alignment of interest with its investors. Raising a larger successor fund can bring GPs more revenue even after accounting for a drop in the fee percentage, said Stoff. A problem can arise when too much of the fund manager’s compensation and revenue is generated from fee revenue as opposed to performance-based carried interest.

Stoff suggests that GPs raising larger funds should lower the management fee further while increasing the carry percentage to ensure that variable remuneration creates the largest proportion of income for the firm.

The study found that a $2.5 billion fund charging 1.75 percent in management fees and a 20 percent share of the carry would mean just about half of the advisor’s revenue would come from fees (under the assumption it produced a multiple of 1.75x). The same scenario using a 1-and-30 fee model would mean only 24 percent of remuneration was produced by fees.