Lecture 8: Distribution of Fund Returns Flashcards
Are fees in PE performance related?
No
What are the 3 fee components in PE?
- management fees
- portfolio company fees
- extra fees and costs
Who pays the 2% AUM management fees to GPs?
LPs
What are portfolio company fees? And who pays them to whom?
- Transaction fees between 1-2% of the transaction value (often included in purchasing price)
- monitoring fees 1-5% of EBITDA
- paid directly by portfolio companies to the GPs (often shared with LPs)
What do the extra fees and costs refer to?
- Penalties when LP miss a capital call
- IB, underwriting, syndication fees
Where are the fee components normally classified?
Usually specified in the Private Placement Memorandum (PPM) and finally determined in the Limited Partnership Agreement (LPA)
What is the typical compensation structure in PE? What does 2/20/8 refer to?
It consists out of Management Fees and Carried Interest.
- Management fee (2% of:)
- basis (e.g. % of committed capital or invested capital–> usually of committed capital at beginning and later on it is on invested capital)
- level (e.g. decreasing fee schedule, percentage falling after investment period) - Carried Interest
- 20% of profits after investors received back all their money invested (money invested + management fee) & after investor receives 8% return compounded annually.
–> So only after money has been repaid and 8% return is achieved then 20% of earnings are carried interest for the GPs
What are catch-up provisions?
- specify the speed with which GPs earn carry
What are Waterfall distributions?
refers to the timing of the payment
What are the 4 periods in the funds lifecycle and how long do they take?
- Fundraising 1-2 years
- Investment Period 3-5 years
- Harvesting Period 5-7 years
- (Extension) up to 2 years
What happens during the fundraising period?
- commitment of capital. Several closings as more LPs commit capital.
What happens during the investment period?
GPs actually do the investments.
- capital calls occur
- drawdowns are possible until the end of the investment period
- here GPs do the investments in new target companies. After this periods no new target companies can be invested in.
What happens in the harvesting period?
Here the GPs do not invest in new targets anymore but can still invest more money in existing portfolio companies.
- Here the GPs look for exit opportunities
What is the extension period about?
- GPs might deem it necessary to exit after the harvesting period as they might not be able to exit properly under pressure. Often not problematic as LPs rather wait for higher returns.
What are draw-downs?
Drawdowns, or capital calls, are issued to limited partners when the general partner has identified a new investment and a portion of the limited partner’s committed capital is required to pay for that investment.
What is the difference between the hard and the soft hurdle rate?
In the hard hurdle rate (e.g. 8%) the LPs receive the preferred return (8%) on their investment and after this hurdle rate, the proceeds are split 20/80.
In the soft hurdle rate, the hard hurdle rate holds until 8% but then the PE gets 100% of proceeds until e.g. 12 % (so until GPs have received their share of the carried interest split) and then there is again the 20/80 split of returns.
What is a distribution waterfall?
It is a pre-arranged arrangement by which the capital gained by the fund is allocated between the limited partners (LP) and the general partners (GPs)
What are the two types of distribution waterfalls?
- American Waterfall
- European waterfall
What is the American Waterfall?
- allows GPs to earn a carry when there is a complete return of capital and preferred return on a specific investment (like GPs already get a % on the first deal, but in Europe, it is not deal-by-deal basis but back-end)
- GP receives carried interest as soon as the fund generates profitable exits from its investments (regardless of potential losses of subsequent investments)
–> GP friendly
What is the European Waterfall?
- GPs don’t earn their carried interest until they return all the investors’ capital, plus a preferred return
- no interim carried interest is paid to GP
–> Rebalances risk
What is the hurdle rate distortion?
GPs take too much risks if it too difficult for them to reach the hurdle rate.
What is investment pressure conflict of interest regarding fee structure?
When GPs have an incentive to invest the full amount of commitments as soon as the management fee basis switches to invested capital (usually after the investment period) –> may lead to bad deals at the end of the investment period
What does NAV management refer to?
When GPs want large NAVs so they can receive high management fees
What is a zombie fund?
A fund that delays liquidation, although it performs poorly. GPs still receive management fees.
