CandidCapital

Neither the remuneration nor the taxation of private equity fund managers is straightforward. But understanding how managers are paid is key to understanding much of the current controversy about the role of private equity in the economy. Part 1 of this blog covers fees and related items. Part 2 covers taxation.

The title of this piece may seem provocative. An urban myth has it that the new CEO appointed to turn round an ailing Fortune 500 corporation was asked by a journalist, ‘How many people work at head office?’ To which he replied, ‘About half of them.’ And by analogy, many readers asked how much private equity managers are paid may simply be tempted to answer ‘too much’.

But the details of how PE managers are paid explain a lot about the current controversies surrounding the industry. They also go some way to explaining why many successful venture firms morph into private equity investors, not necessarily to the benefit of the economy.

The key issues are as follows. PE firms can expect (1) an annual advance profit share of funds under management (2) fees for making investments, acting as non-executive directors or monitoring management information and (3) a carried interest or performance bonus. In addition (4) careful planning can greatly reduce the amount of capital gains tax payable on the bonus element; and (5) a number of managers have benefited from non-UK residence status for tax purposes. Often also, (6) the debt taken on by companies involved in PE transactions such as a delisting will amplify the return to investors and so increase the bonus paid to the fund manager.

Hence the headlines about the inhabitants of Mayfair paying less tax than their cleaners. But before deciding if the critics are right, let’s break down PE remuneration into its constituent elements.

Annual Fees

In theory, PE managers are mainly remunerated through sharing in the uplift in value of the funds entrusted to them. For a variety of historical and tax reasons, many PE funds are structured as limited partnerships (in England, under the Limited Partnerships Act 1907). Such partnerships have ‘limited partners’ (LPs – think of them as being like the institutional shareholders in a limited company) and a ‘general partner’ (GP, which has joint and several liability for the debts of the partnership).

The partnership is often referred to as ‘the fund’. A limited partnership is tax-transparent, benefiting investors such as pension funds who are tax-exempt as the partnership itself will not pay tax on profits but pass them through to investors in their entirety.

Usually the GP appoints the fund manager, although the GP may itself act as the fund manager. Either way, the GP would normally receive an annual general partner’s share used to pay for fund management activities. The GP share is usually expressed as a percentage of funds under management, though there are several possible permutations here.

For instance, at the smaller end of the market where the fund size is £5M or £30M– really the VC end rather than private equity – the GP share is in the 2% to 2.5% range a year, with smaller funds having higher percentages. For larger funds (above £250M) the fee may be only 1% - 1.25% a year, with tapering and other variations on a theme in between.

Sometimes the GP share will be a fixed percentage of committed capital during the investment period (the first 5 years, say) then be a fixed percentage of funds in live investments. Sometimes also, especially with the proliferation of government-backed funds in the UK, set-up costs (1%?) can be charged on a one-off basis and a small annual fee (0.25%?) for audit, legal and custodian fees.

The advantage for the fund manager of having a separate admin fee is that although the 0.25% a year is paid out to third parties such as auditors, it does not count as an advance share of profit when it comes to calculating the carried interest – of which more below.

To keep the example simple, the annual fees charged by different sizes of fund might look something like the following:

The received wisdom is that it takes almost as much time and effort to arrange and monitor a £500,000 deal as a £5M deal. And as the long-run statistics show (something we shall return to in Candid Capital) larger deals have generally been less volatile than smaller ones. So there are several advantages for the manager in raising a large, late-stage fund for leveraged buy-outs (LBOs). It is much more time-consuming and precarious at the VC end of the market where you spend your time building businesses.

It will probably take 5 people of different levels of seniority to run a £50M fund, but it will not take 35 people to run a £700M fund. Over the years at Candid Capital we have had managers of £100M admit to us privately that about half the general partner’s share is pure profit. But this is not a subject that will ever be aired in public, although in his evidence to the House of Commons Treasury Committee, Jon Moulton of Alchemy tackled the issue with characteristic realism (paragraph 79):

"The institutions give us the same terms essentially for a £100 million fund as for a £10 billion, 100 times the fees and income. The costs of running the funds do not go up by a factor of 100. … Nobody forces the institutions to do it."

So we are part of the way towards understanding why tickets to the BVCA annual dinner at the Grosvenor House Hotel (where you can hear a comedian, but not much about VC) cost £120 a head. But only part of the way.

Fees from Portfolio Companies

Another significant source of income for the manager during the life of the fund is made up of the fees that the manager can charge once investments are made.

You may be familiar with the trick your bank plays on you of charging an arrangement fee when you take out a loan: the theory is that this covers the cost of reviewing and documenting your application. Something similar happens with investments made by PE firms.

Assume a £300M fund with investments in 15 companies averaging (across the rounds) £20M. With an average of 2 rounds per investee, the fund manager will have negotiated some 30 deals during the investment phase (say the first 5 years) and will have been rewarded for doing the deals over and above the management fee charged to the fund.

With large transactions, a full 1% may not be obtainable from the investee companies, but over the life of the fund, even 0.5% on a £300M fund will produce an additional £1.5M. And remember, that is often on top of the £3.75M charged to the fund as a 1.25% annual fee. Even where these fees go back to the fund to offset the annual fee, they contribute to reducing the advanced share of profit and thereby increase the carried interest payable to the fund manager.

So £5.25M in fees has so far been received by the fund manager. But it does not stop there. For each investment made, the manger would expect to receive monitoring fees or fees to compensate members of the management team for acting as non-executive directors of portfolio companies.

Again, rates will be negotiable, but to take a reasonable example, assume that 10 of the 15 investee companies in the portfolio survive. Then assume that £16,000 a year is charged as NED fees per company per year (this is at the low end of what AIM-listed companies might pay). The fund manager is receiving an additional £160,000 a year in directors’ fees. Not enough to redecorate the Mayfair office, but almost enough to pay the salary of the junior partner.

So with total fees in the middle years of a £300M fund either side of £5M, you can begin too see why in addition to the annual dinner at the Gro Ho, the BVCA has ski-ing weekends, sailing days and golf days.

Carried Interest

The next major component of PE remuneration is the carried interest or performance bonus.

Again, figures will vary from fund to fund depending on the reputation of the manager and current market norms, but as a benchmark the fund manager would expect a 20% carried interest. (A few of the most successful firms in California have an even higher carried interest percentage, but they are so much in demand that you would become an investor by invitation only.)

The carried interest is the proportion of any gains realized by the fund to which the manager is entitled (over and above any investment in the fund made by the principals themselves). The intention is to create a significant alignment of interests between the LPs and the manager because the fund manager has a strong economic incentive to achieve capital gains.

How much the carried interest is worth will obviously depend on the size and success of the fund. But let’s take another simple example. The BVCA performance survey for 2006 shows that mid-to-large MBO funds raised in 2001 have an internal rate of return (IRR) of 29%. According to the conversion tables helpfully provided by Coller Capital, a 26% IRR after 6 years is equivalent to a 4x multiple of original capital.

So if a mid/large MBO fund was originally worth £500M, it would now be worth £2,000M. Of the increase of £1,500M, 20% - £300M – would go to the manager.

If this seems excessive, the obvious retort is that the manager had to produce the 4x return in the first place. And in principle, the LP investors would still have done well to have a net £1,200M (or 2.4x) return on their money. And using the same BVCA data, venture funds have been consistently negative except for vintage years (the year when the fund was raised) 1997 and 2002, so other things being equal both rational investors and rational managers would give venture a miss if they believe the past is a reasonable guide to the future.

The figures I have quoted also exaggerate to make point. It is (now) normal for the manager to have to clear a minimum level of return (the ‘hurdle rate’) before participating in the carried interest. The hurdle rate today might be 8% or 10% today.

However, it has been the sheer consistency of return for the fund manager that has made the carried interest structure look to outsiders like shooting fish in a barrel. Hence the call in the Walker Review for greater transparency on the remuneration terms and relative performance of fund managers. The interim report consulted, for instance, on the following proposal for information to be included in a general partner’s annual review:

‘a broad indication of the performance record of their funds, with an attribution analysis to indicate how much of the value enhancement achieved on realization and in the unrealised portfolio flows from financial structuring, from growth in the earnings multiple in the market in the industry sector, and from their strategic and operational management of the business.’

This ends Part 1 of our review of how private equity managers are rewarded. Part 2 (to appear tomorrow) will cover how private equity is affected by tax.

14 August 07