PE Fund Economics

Question 1

PE funds generate revenue

Answer 1

management fees and carried interest

- other sources are deal fees, monitoring fees

Question 2

Management fees

Answer 2

• meant to cover a PE firm’s annual operating budget
• used to make new investments and manage their existing portfolio
• LPs pay management fees to the PE firm based on a percentage of the PE firm’s AUM

Question 3

Carried Interest

Answer 3

• its the PE firm’s share of profits made by the investments they made
• its the main incentive for GPs to make highly profitable investments and keep a percentage of the profits after returning principal
• can be earned on profits from exits and dividend recaptilizations
• in order to earn carried interest, pE firm needs to generate returns in excess of 7-8% known as the hurdle rate

Question 4

Deal Fees

Answer 4

When a PE firm closes a deal, it frequently charges the target a deal fee calculated as asmall % of the total deal size. These fees are often shared with LPs.

Question 5

Monitoring fees

Answer 5

Portfolio companies frequently pay nomina fees to their PE owners ascompensation for the owners’ ongoing monitoring and managerial assistance.

Question 6

Why PE firms must generate high returns?

Answer 6

1. Investments are illiquid. Its not the same as market investors that can sell their stocks and can money back. PE firms hold investments for around 5 years
2. PE firms are risky because they use a high amount of leverage to finance their acquisitions, which increases chances that portfolio companies will default and take out the invested equity
3. Timing is unpredictable. When LPs commit to a PE firm they can be called to provide financing at any time over the next several years, and its unpredictable how long these investments will take to generate returns and how large the financing for the investment will be

Question 7

Why does PE generate higher returns than public markets?

Answer 7

PE LPs demand higher returns than public market investors which causes PE investors to price their deals to an IRR of 20% or higher. PE LPs demand these higher returns for two main reasons

1. LBOs are highly leveraged making PE investments riskier than public stocks
2. PE investments are much less liquid than public stocks; it can take up to ten years to realize returns