Ah, private equity: the promised land. Glamor, seven-figure pay, and even the occasional sadistic Partner who makes you cold-call companies all day.
But why do you actually make so much money in private equity? What makes it so profitable?
Does it depend on the type of fund you’re at? Who gets paid what, and when? Will it last for the next 20 years, or are the industry’s best days behind it?
We’ll get to all of that – and more – but let’s start at the beginning and take it from there.
What Are Private Equity Funds?
Private equity is an umbrella term for different types of investments in private companies or in publicly listed companies that will become private as a result of the investment. That’s what the “private” part refers to – we’re not dealing with investments in the stock of public companies here. The bulk of the investing is done through private equity funds, which are investment schemes.
PE funds are managed by a General Partner (GP) – the firm itself and everyone who works there – and funded by several Limited Partners (LPs) – pension funds, banks, insurance companies, high net worth individuals, etc. – anyone who has enough cash to invest.
In “Cold Call to Closed Deal” the GP is the firm that the protagonist is working at, and the Limited Partners are people like Paul and Simon who invest in PE funds themselves.
The GP provides a portion of the capital (at least 1%) and some funds also use debt to finance their investments.
The size of PE funds varies widely from approximately $100M (sometimes less) to tens of billions; the size depends on the type of fund (buyout funds are bigger), the reputation of the GP (top firms with strong track records have an easier time raising large funds) and the region (some countries have smaller funds than others).
Common fund types include buyout, venture capital, growth equity, mezzanine (subordinated debt and preferred securities), special situations (investments in financially-challenged companies), real estate, and infrastructure funds.
Funds usually focus on one or more sectors (otherwise they are known as “sector-agnostic”) and target specific geographic regions.
A few of the more common ones that you might join one day:
- Leveraged Buyout (LBO) Funds acquire 100% of mature companies, using both debt and equity to finance their acquisitions (the debt portion usually accounts for 50-85% of the purchase price). Examples are the likes of KKR, Blackstone, and TPG – the biggest and most prestigious names in the industry.
- Venture Capital (VC) Funds usually acquire minority stakes in startup companies in sectors with high-growth potential, such as technology or biotechnology. Examples include Sequoia, Kleiner Perkins, Accel, and Andreessen Horowitz.
- Growth Capital Funds invest in reasonably mature companies that are looking to scale-up their operations (organically or through an acquisition) or penetrate new markets; these are somewhere in between LBO funds and VC funds in terms of assets under management and investment size. Examples are Summit Partners, JMI, and TA Associates.
Funds tend to be classified in specific buckets, but the sky’s the limit when setting a fund’s strategy! Many firms have also expanded into different strategies over the years, or started new spin-off firms that make different types of investments.
How Are PE Funds Structured?
A private equity firm, as the General Partner (GP), raises a private equity fund by soliciting investments from various investors (institutional investors and high net worth individuals) known as Limited Partners (LPs).
Private equity firms usually manage several funds (depending on the size of the firm) and attempt to raise a new fund every few years. Each fund invests in a number of companies, known as portfolio companies.
The role of the LPs is usually passive and is limited to providing the capital. As such, LPs are not consulted about investment decisions and they rely on the GP to monetize the investments.
The part in “Cold Call to Closed Deal” where Paul gets pissed off about the investments John is making is therefore a bit dramatized – normally you wouldn’t see that much involvement from the LPs. But they could very easily not be impressed by a firm’s overall performance and therefore not invest again.
Funds are set up as Limited Partnerships between one GP and a number of LPs. The parties will agree on a number of terms specified in a Limited Partnership Agreement (LPA), which often exceeds 100 pages. Each LP can also request specific conditions in a side letter. The LPs have a limited liability corresponding to their commitment to the fund, while the liability of the GP is unlimited.
Important terms agreed upon in the LPA include the term of the fund (usually 10 years + 2 possible one-year extensions); the management fee (usually 1.5 to 2% p.a.), the distribution waterfall (i.e. the way profits are split and distributed), LPs & GP rights and obligations, and limitations imposed on the GP (e.g. type & size of investments, geography, diversification requirements).
Show Me the Money! Where’s the Money?! I Want My Bonus!
So let’s get down to what you’ve been waiting for: why do you make so much money, and who gets what?
Bankers make money the same way Ari Gold makes money: they represent companies, sell them, and raise money for them, and earn a commission on each transaction.
But PE firms make (most of) their money by exiting their investments and selling companies for a higher price than what they paid to purchase them.
The profits are split according to a distribution waterfall (the portion received by the GP is referred to as the carried interest or carry – usually 20%) and the GP also receives management fees.
When private equity was first beginning, firms charged the LPs a management fee to “keep the lights on” and cover the fund’s operating costs before they had invested in anything; unlike a normal business, it might take a new PE firm years and years to realize a profit.
Decades later, that same management fee has persisted and is mostly used to pay salaries: a common formula is 1.5% to 2% of the committed fund size (paid to the GP by the LPs) during the investment period (i.e. the period during which new investments are allowed – usually the first 5 years), with a decreasing schedule afterwards.
For example, after the 5th year, the fee might decrease by a certain percentage every year or be charged on the net invested capital (i.e. capital invested in active portfolio companies) as opposed to the committed capital.
Management fees represent a significant amount of money over the 10-year life of the fund and are not linked to performance at all. Just imagine: a $100M fund with a 2% management fee would earn $2M per year and a $1B fund would earn $20M per year (for at least 5 years), regardless of their performance!
And that’s why PE firms can afford to pay such high salaries: the biggest funds might have tens of billions under management, and therefore have hundreds of millions each year for employees.
Just as in banking, there are few other expenses so they can afford to pay employees lavishly.
And remember what the headcount at these places is like: even the biggest firms such as Blackstone and KKR only have a few hundred investment professionals.
The average pay could easily top $1 million or more per employee – though of course the senior people always earn more and the juniors always earn less.
The Distribution Waterfall
The management fees explain why PE salaries are so high, even in an average year or when the firm hasn’t had great exits.
But if you want to understand why people like Henry Kravis or Steve Schwarzman can make $500 million+ per year, you need to understand the distribution waterfall.
The most common waterfall is an 80/20 split between the LPs and the GP. This means that the GP receives 20% of the profits – known as the carry (to be split between the firm’s partners and staff), while the LPs receive 80% of the profits (to be split between the LPs according to their contribution to the fund).
In other words, the LPs receive 100% of the capital they have committed to the fund, and for each extra dollar, the GP will receive 20 cents and the LPs, 80 cents.
And that’s why the Partners at the PE firm make so much: they get 20% of the profit, but only contribute 1% to 5% of the total capital.
Just as a simple example of how this works: let’s say that the firm has just raised a $20B fund, and they invest $2B of capital in new companies. A few years later they exit those investments for $3B.
In this scenario, the LPs would get their $2B of capital back (slightly less than that if the GP actually contributed 1-5% of the total), and would then get 80% of that $1B gain, or $800 million.
Then the GP – the Partners at the firm – would get 20% of that $1B gain, or $200 million.
Technically that’s supposed to be split between everyone at the firm, but in reality the most senior Partners rake in the bulk of it – which explains how the top people at the biggest firms in the world consistently make bank.
But you see a second implication as well: if the fund is much smaller or doesn’t perform well, the numbers aren’t nearly as good.
Often the carry is subject to a hurdle rate or preferred return, meaning that the GP must generate a certain annualized return (often around 8%), before being entitled to the carry.
As a simplified example (and assuming no catch-up clause), in the case of a $100M fund, the LPs would first receive $108M and the excess would be split on an 80/20 basis.
But, when the fund is subject to a hurdle rate, the GP is often protected by a catch-up clause. Continuing with the same example, after the LPs have received their $108M, the next $2M would go entirely to the GP (to shift the split back to 80/20 ? the GP gets $2M/$10M of profits = 20%) and any additional profits would be split on an 80/20 basis.
This sounds great and when the fund is very profitable, all parties (especially the GP) can make a ton of money – but frequently the GP doesn’t receive carry in poorly performing funds, and it is not uncommon for LPs to get back less than their committed capital.
You always hear about the outliers that earn absurd amounts of money, but the average case is far less glamorous: not all investments perform well, and you often lose money.
What Do GPs Do to Earn so Much?! Do They Really Deserve It?
GPs get millions in management fees simply for setting up and managing funds, and then 20% of the profits (if any are generated) – no wonder PE salaries are so high!
So what does a GP do to earn so much?
- Raise funds from Limited Partners.
- Source and execute investments.
- Manage and monitor those investments.
- Generate returns by exiting investments.
To stay in business, private equity funds must raise new funds by securing commitments from external investors.
This is what John was worried about in Part 1 of “Cold Call to Closed Deal” – they needed to raise another fund ASAP, and were putting the resources of the firm behind it.
In reality, a larger firm would rely more on outside fundraising people and not quite as much on the firm’s own employees.
Capital Raising – Where Does the Money Come From?
PE funds can be split into 2 categories: captive and independent. In a captive fund, all the capital is provided by the GP, which might be a bank, an insurance company, a pension plan or a wealthy individual.
In the case of an independent fund, the GP provides a portion of the capital (often 1 to 5%) and raises the remainder from the parties above, reaching out to several LPs in order to secure capital commitments. The GP can also use the services of a placement agent, which is basically an external fundraising team.
A substantial commitment is required from any LP – usually north of $ 1M, and often more – so that only wealthy people who know what they’re doing can invest.
LPs commit to a certain amount, but do not disburse the full amount on day 1. The capital is drawn progressively by the GP from the LPs through capital calls, as investments in companies are made. The commitment is referred to as the committed capital, while the disbursed portion is the contributed capital.
Funds often have a first close and a final close. When the first close is reached, the fund can start investing in companies, but it is still possible for new investors to join the fund (usually for one year). Once the final close is reached, new investors can no longer join in.
Sourcing and Making Investments
Key factors to consider include the product/service & strategy, the team, the industry, the entry valuation and the exit prospects.
Deal flow (prospective investments) can be generated by the firm’s reputation (companies will reach out to the firm), internal staff (who will reach out to interesting companies through their contact network or cold-calling) or investment banks (who represent the company seeking capital and will often run an auction process).
In “Cold Call to Closed Deal,” the IonX deal comes to the firm via a contact at an investment bank – that scenario was unusual only because the bank wasn’t shopping the company around to other firms.
To have access to good proprietary deal flow (i.e. access to deals before other prospective acquirers), the GP maintains good relationships with bankers, advisers and key people in the industry.
Once an interesting investment has been identified, the team then conducts due diligence to evaluate the company’s business model & strategy, team, market, financials, risks, and so on. If no “deal killers” are uncovered, they’ll seek approval from the GP’s investment committee, negotiate final terms, and make the investment.
Managing and Monitoring Investments
The GP does not run the day-to-day operations of its portfolio companies, but some provide support for strategy, operations and financial management.
The level of involvement depends on size of the stake purchased – generally, the smaller the ownership stake, the less involved the GP will be. The GP must also monitor the progress and valuation of its portfolio companies and provide updates to the LPs, usually on a quarterly basis.
Generating Returns by Exiting Investments
The ultimate goal and raison d’être for a PE firm!
The usual exit horizon is approximately 3 to 7 years, but it can also be more or less if there’s a solid, strategic reason to do so.
Most exits are realized through an IPO or an M&A. Two common metrics are used to measure returns: the internal rate of return (IRR) – in technical terms: the discount rate that makes the NPV of all cash flows equal zero – and the multiple of cost (MC) – (cash distributions + unrealized value)/capital invested.
The IRR is time sensitive, while the multiple of cost is not. For example, if a $20M investment is sold for $40M (a) after 1 year: MC = 2x and IRR= 100%, (b) after 3 years: MC = 2x and IRR= 26%, and (c) after 5 years: MC = 2x and IRR= 15%.
The Partners are heavily involved in exiting investments, but they also call on investment banks to handle much of the execution there – which is how banks earn a lot of their fees.
So, Will the Sky-High Bonuses Last?
The short answer is yes, at least for the foreseeable future. There has always been talk that LPs will start to demand a different management fee structure and a more favorable distribution waterfall, but nothing supports those changes at the moment.
Even if management fees somehow dropped by 50%, the average per-employee pay would still be close to $1 million – more than almost any other industry, and PE firms themselves would still have few expenses.
And even if the distribution waterfall shifted to 90/10 or 85/15, Partners would still make a ton of money on good investments.
Pay at investment banks, especially in areas like sales & trading, is far more likely to fall in the future because banks are much larger than PE firms and draw more government scrutiny and regulation.
So even if it’s doomsday and pay at banks has fallen dramatically, you’ll still earn something in private equity – even if the firm itself has to shut down due to poor investments.
You’ve now learned pretty much all the basic information and even some of the lingo you need to appear well-informed during a PE interview!
Stay tuned for the next feature in this series, where we’ll explore PE in emerging markets – the hot markets & trends; the key differences; and the risks & rewards involved.