Uncovering the Costs and Benefits of Private Equity

Private equity fees are like snowflakes: abundant, unique, and lacking in transparency.

April 13, 2016

Private Equity fees are abundant in that the headline fee levels are high, especially relative to public index strategies. Private equity fee structures are unique because each Limited Partner Agreement (“LPA”) is closely negotiated between GPs and LPs. The result of these complex and varied negotiations is that private equity fees lack transparency. This lack of transparency is often driven by the complexity and variability of definitions of fees.

The amount and complexity of fees has received a significant amount of attention in recent months. Institutions are pushing to reduce fee levels and increase transparency. In some cases LPs have had difficulty in calculating how much they actually pay in fees. For a large investor such an exercise is not trivial.

The complexity leaves room for unscrupulous GPs to take advantage of their investors; in fact, the complexity can make it difficult even for conscientious GPs to adhere to their own policies and procedures. The resulting confusion can make it impossible to have a rational discussion about the real costs and benefits of investing in the asset class. This paper will attempt to provide greater understanding about the different conventions used by GPs and LPs in defining how GPs are to be compensated for the services they provide, as well as to answer the question of whether this compensation is generally justified.

Abundant Private Equity Fees

As a starting point, we will present the basics of private equity fee structures. A GP creates a fund governed by an LPA. The GP advises the fund which portfolio companies to invest in, as well as provides active management of that portfolio through to its liquidation. As compensation for these services, the GP is entitled to certain fees. In addition to these fees, LPs agree to reimburse certain types of expenses associated with the management of the fund. The LPA defines these relationships and the split of fees and expenses. LPs and GPs negotiate the terms of each LPA based on the specific risks and merits associated with each fund, as well as the relative negotiating power of LPs versus GPs.

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