Tito's Blog

Thoughts On Private Equity Carried Interest

Update: carried interest example spreadsheet on google docs. Full blog post below.

Funds investing in alternative assets (hedge funds, private equity and venture capital) usually receive a compensation known as “2-20”: 2% of committed capital as yearly management fee (irrespective of the fund performance on its investments) and 20% of any capital gains that the fund realizes when it sells any of its portfolio companies, called “carried interest” or simply “carry”.

But as usual the devil is in the details. The bylaws of a fund define how and when the carried interest is distributed to the fund managers. Conceptually, a carried interest is disbursed only when the fund investors (also known as “limited partners”) have received their capital back plus a nominal interest rate compounded annually (the “hurdle rate”, usually for private equity and venture capital funds 8%).

For example, suppose that you raised $1 billion from institutional investors in 2006 to execute leveraged buyout deals. In a leveraged buy-out deal, a fund finances its investment in part in equity and in part in bank debt. Before 2008, up to 70% of the acquisition price was financed in debt, which allowed private equity firms to acquire big companies with relatively low equity commitments. The availability of cheap debt also caused acquisition prices to go up, similarly to how low-interest mortgages fueled the real estate bubble.

The catch is that you really do not get to invest the full $1 billion because the $1 billion is also used to pay management fees. Most private equity and venture capital funds have a lifetime of 10-12 years. In the first 4 years (2006-2009 in our example), the fund can make investments, and in the next 6-8 years the fund will have time to divest from its portfolio companies and hopefully realize a capital gain. During the investment period of 4 years, the fund managers receive a full 2% management fee of the initial committed capital to pay salaries and cover expenses every year, and later on they will get a reduced management fee calculated on the capital actually committed. Let’s say that over the life of a fund, 12-14% of the total capital are used to pay management fees (8% during the investment period and 4-6% as the fund starts divesting).

In addition, a portion of the total capital is usually allocated to follow-on investments on portfolio companies. For example, a fund will keep 10-15% of its capital under management to be ready if a new attractive investment or acquisition opportunity comes up for a portfolio company or if an under-performing company needs more capital than expected or banks require an equity injection from the shareholders of a company that breached its acquisition financing covenants (which I would say happened or will happen in over 80% of all LBOs closed before september 2008).

In our example, let’s assume that your private equity firm had really planned to invest only $700 million during its investment period or about $175 a year, considering about $140 million in management fees (it is a tough life, I know), and $160 million in follow-on investments.

In 2006 and 2007, your firm is off to a good start investing $350 million of equity in 5 different companies with (once) solid cash flows that allowed your fund to lever up your investment to maximize your return on the equity invested. In other words, let’s assume that you acquired a majority stake of 66% in 5 companies, each generating $26 million in EBITDA and valued (or bid up to) $260 million in EV (enterprise value) or 10x EBITDA. Banks were queueing up to offer acquisition financing worth $155 million on each deal with the remaining $105 million to be financed in equity, or $70 million for our 66% stake.

Fast forward to 2009. So far your investors have put to work $430 million, $350 million in actual investments and $80 million of management fees for the first 4 years. You could not make any investment in 2008 and 2009 because acquisition debt dried up. The 5 companies you invested in now make an average $20 million in EBITDA and are valued only 7x EBITDA, for an EV of $140 million. Since they are still indebted with over $150 million of acquisition financing, the equity value of these companies is negative.

Before you start seeing any carried interest, your fund will have to generate enough proceeds to reimburse $430 million plus 8% of hurdle rate compounded yearly, for a total of over $500 million (see carried interest google spreadsheet).

In the downcase scenario of our example, your investments so far are worth zero. You probably have to inject more capital in your portfolio companies, due to triggers in acquisition financing debt that now exceeds 7x EBITDA and some of your companies are defaulting on the first debt reimbursement. And by the way the investment period is almost over, even though you are still sitting on about $350 million of cash.