Lecture 8: Distribution of Fund Returns

Question 1

Are fees in PE performance related?

Answer 1

No

Question 2

What are the 3 fee components in PE?

Answer 2

• management fees
• portfolio company fees
• extra fees and costs

Question 3

Who pays the 2% AUM management fees to GPs?

Answer 3

LPs

Question 4

What are portfolio company fees? And who pays them to whom?

Answer 4

• 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)

Question 5

What do the extra fees and costs refer to?

Answer 5

• Penalties when LP miss a capital call
• IB, underwriting, syndication fees

Question 6

Where are the fee components normally classified?

Answer 6

Usually specified in the Private Placement Memorandum (PPM) and finally determined in the Limited Partnership Agreement (LPA)

Question 7

What is the typical compensation structure in PE? What does 2/20/8 refer to?

Answer 7

It consists out of Management Fees and Carried Interest.

1. 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)
2. 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

Question 8

What are catch-up provisions?

Answer 8

• specify the speed with which GPs earn carry

Question 9

What are Waterfall distributions?

Answer 9

refers to the timing of the payment

Question 10

What are the 4 periods in the funds lifecycle and how long do they take?

Answer 10

1. Fundraising 1-2 years
2. Investment Period 3-5 years
3. Harvesting Period 5-7 years
4. (Extension) up to 2 years

Question 11

What happens during the fundraising period?

Answer 11

• commitment of capital. Several closings as more LPs commit capital.

Question 12

What happens during the investment period?

Answer 12

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.

Question 13

What happens in the harvesting period?

Answer 13

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

Question 14

What is the extension period about?

Answer 14

• 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.

Question 15

What are draw-downs?

Answer 15

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.

Question 16

What is the difference between the hard and the soft hurdle rate?

Answer 16

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.

Question 17

What is a distribution waterfall?

Answer 17

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)

Question 18

What are the two types of distribution waterfalls?

Answer 18

• American Waterfall
• European waterfall

Question 19

What is the American Waterfall?

Answer 19

• 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

Question 20

What is the European Waterfall?

Answer 20

• 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

Question 21

What is the hurdle rate distortion?

Answer 21

GPs take too much risks if it too difficult for them to reach the hurdle rate.

Question 22

What is investment pressure conflict of interest regarding fee structure?

Answer 22

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

Question 23

What does NAV management refer to?

Answer 23

When GPs want large NAVs so they can receive high management fees

Question 24

What is a zombie fund?

Answer 24

A fund that delays liquidation, although it performs poorly. GPs still receive management fees.