Within private equity there is a holy trinity of terms – carried interest at 20 percent, management fees at 1.5-2 percent and a preferred return of 8 percent. These terms have become a standard and are applied to virtually all private equity funds no matter their size or purpose, and this creates anomalies.

In the second of this three-part series, I examine management fees.

In its infancy private equity adopted the fee structure found in oil and gas funds, and the general rate was set at 2 percent of funds raised. Most funds were in the range of $50 million to $200 million and therefore the fees generated were just sufficient to hire decent staff and make, manage and exit investments.

Over the past 25 years funds there has been a transformation in the private equity industry. Fund sizes have grown, new funds are being raised every three to four years and there has been the emergence of the multi-asset manager encompassing the whole gamut of alternatives from private equity through to private debt, infrastructure and real estate, with each segment generating substantial fees. The result is that management fees have become a significant component of private equity managers’ earning, diminishing the exclusive focus on maximising carried interest.

Most private equity funds have a life of 10 years with a further two or three years added to allow for an orderly disposal of residual assets. The management fee is usually charged on committed capital less the cost of investments realised or written off. This creates a long tail of fees and every three to four years a new fund is raised (usually the same size or larger than the previous fund) resulting in the stacking of fees. It is unlikely that the increase in marginal revenue is matched by an increase in marginal costs as a new fund does not require the recruitment of an additional team.

To add insult to injury, the management fee is charged on capital committed and not invested capital. As an illustration a £100 million ($129 million; €111 million) fund with a management fee of 2 percent draws down 10 percent of its capital in year one, which means that it will invest £10 million and charge a management fee of £2 million equivalent to an actual rate of 20 percent. This creates “fee drag”, meaning that the management fees in the early years of a fund’s life have a highly corrosive effect on investors’ net returns.

Carried interest

If only management fees were the only source of fees for private equity groups. There are other corporate finance fees, such as transactions fees, that can be levied, albeit that they are now shared with the investor as an offset against the management fee and to pay for any abort costs. However, the question is whether the private equity group should enjoy any of these fees at all because, without the investors’ capital, they would not be in a position to make any investments.

The problem is that fees are charged per fund without any recognition of the overall size of the group and its fee generating capabilities. While it was acceptable in the past – when private equity AUM were low – to charge per fund, it is less acceptable now as AUMs are now running into the billions. Private equity groups need to become more transparent about their revenues and profitability as businesses and fees should be more reflective of marginal costs.

Private equity cannot have it both ways – either significant carried interest or high fees – but not both. As in most corporate finance situations it is acceptable to pay a modest retainer and a huge success fee.

Ray Maxwell is the chief executive of priv-ity, which provides strategic investment advice to institutions and to SMEs.