Central to private equity’s claim to add value beyond financial engineering is the principle of alignment of interests – a chain linking management of companies through the financial sponsors themselves to investors in the funds. There is something to that, but the latter half of the chain is weakened by private equity’s curious fee structure.

Typically, a “general partner” – the private equity house itself – earns two sets of fees. One is a management fee of, say, 2 per cent of invested funds – that is, capital committed by the investor, or “limited partner”, and deployed. The other is the “carry”, or the performance fee private equity earns on the fund when things go right. This is usually 20 per cent of profits above a hurdle rate of, say, 8 per cent.

Management fees of 2 per cent seem reasonable until you consider the rise of mega-funds. A much bigger fund may require some more resources to manage it. But scale ought to provide some operating leverage, leaving room to cut fee rates. Private Equity Intelligence estimates industry-wide management fees at $18bn, compared with total carry of $24bn. That suggests carry remains a powerful incentive for general partners to do well – although, at 57 per cent, it is no longer the overwhelming slice of the pie.

Perhaps more problematic, however, is the way in which carry is calculated. Most funds use a hurdle rate, but also employ “catch-up” clauses. Under these, once profits rise above the hurdle level, the general partner claims any further profits until the 80/20 split is restored – across all profits, including those accounted for under the hurdle level. Hurdle rates, therefore, offer some protection against weak performance. Once breached, however, they are in effect negated. With private equity increasingly under attack from all quarters, acting pre-emptively to realign fees and strengthen the industry’s main selling point would be a worthwhile move.

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