Yves here. Our next set of posts in our private equity series will provide background on how the industry operates.
By Namea, a private equity insider
The contractual terms received by investors in private equity funds are established via negotiation. However, as a practical matter, only the very largest government pension plans and sovereign wealth funds have the power to influence larger funds’ terms, which are embodied in contacts called “Limited Partnership Agreements”. The structure of the agreements tends to be quite standardized. Think of the key terms as a set of toggle switches on a fund — the toggles can be set at a variety of different values but the number of toggles and their purpose vary little from fund to fund. In addition, as the toggle image suggests, the range of outcomes that is permitted is circumscribed.
This post will discuss the first of the main “toggles” for funds, which is the management fee, but first we’ll cover some basic concepts and industry nomenclature.
At the highest level, a U.S. PE fund is almost always structured as a limited partnership, where the investors are limited partners (LPs) and a shell legal entity of the private equity investment firm is the general partner (GP). However, within the industry, everybody refers to the “GPs” of a fund as the natural people who manage the sponsoring private equity firm, even though they technically are not the GP, which is a legal entity. The inaccuracy of this convention is not without consequence in terms of potential cognitive error it can cause. However, the convention is so well established that we’re not going to try to buck it entirely. Instead, we’ll call someone who works at a PE firm a GP* (GP*s for plural. If people in the industry want to adopt this convention but can’t find a way to orally express the asterisk, we suggest calling them “pseudo-GPs”). When we mean the actual legal GP entity, we’ll omit the asterisk.
Limited partnerships are very common legal structures throughout our economy. Their basic concept is that the “limited partner” has no liability for the acts of the partnership over and above whatever financial commitment he or she has made to the partnership. In return for this legal grant of limited liability, the LP is required to cede virtually all control over the partnership to the general partner, which in the private equity context, means that the GP effectively makes the investment decisions and controls the fund. The general partner, unlike the LPs, theoretically has unlimited liability for all acts of the partnership. Though, as we will see, private equity firms typically avail themselves of the opportunity to designate other limited partnerships as GPs of their funds, which significantly muddies the question of where ultimate control and liability rests.
Did you notice that I said that the GP “effectively” makes the investment decisions? It’s actually more complicated. For most funds, the GP actually “hires” an “investment manager” to manage the fund and delegates the GP’s fund management authority to it. But the investment manager is actually just a shell legal entity comprised of exactly the same people as the GP, all those GP*s we discussed earlier . For example, the general partner of the KKR 2006 Fund partnership ($17.6 billion in size) is KKR Associates 2006 L.P., itself another partnership, while the investment manager is Kohlberg Kravis and Roberts & Co. L.P.
KKR has two reasons for separating the GP and investment manager entities. First, KKR wants to be able to assert that its employees “earned” the management fee when wearing their “manager” hat, not when wearing their “general partner “ hat. Should the fund face legal liability, KKR believes that a court will honor this distinction and shield its management fee revenue from claims.
Second, New York City private equity managers are seeking to minimize their local Unincorporated Business Tax (UBT), an annual levy equal to four percent of net income (more on tax issues later…)
The Management Fee
Almost all funds provide for the right of the GP to receive a management fee. A 2% annual fee is generally viewed as the “rack rate” for management fees, meaning that it’s the percentage where negotiations almost always start. Very small funds of less than around $500 million, venture capital ones in particular, are often able to negotiate a higher fee — 2.5% is common and 3% is not unusual—based on the argument that there is a minimum absolute size to the revenue stream necessary to run a PE firm.
Funds larger than a couple of billion dollars face enormous investor pressure to charge less than 2%. Let’s use KKR as an example. Recall the KKR 2006 Fund was $17.6 billion in size. While KKR has never publicly stated its precise management fee for that fund, since going public, KKR has hinted in SEC filings that the management fee is around 1.25%. That percentage translates into approximately $220 million in annual revenues to KKR for managing that fund alone. However, KKR doesn’t get that $220 million every year forever. Instead, the GP gets the money for the duration of a fund’s “investment period”, the time during which the fund may acquire a portfolio of investments, which is viewed in the industry as the most labor intensive part of a fund’s lifespan. The KKR 2006 Fund has a six year investment period, which is a bit longer than the typical five year investment period.
Once the investment period of a fund ends, the management fee stream for the GP continues, although at a lower rate. The rationale for the continuation of a management fee during this “post-investment period” is that the GP is still tending to a substantial portion of the portfolio companies acquired during the investment period. For KKR, the applicable percentage through the tenth anniversary of the fund’s life is 0.75%. Unlike during the investment period, that percentage is applied only to the capital still invested in the fund, as opposed to the original fund size. Beyond the tenth year of the 2006 Fund, KKR is unusual in that it is rumored to still collect a further-stepped-down management fee for a number of years. Most funds lack that feature.
How much does all this management fee revenue add up to? KKR is an interesting example, because it is relatively transparent in this respect due to having recently become one of only a very few publicly-traded private equity firms. We can see from KKR’s SEC filings that, in 2011, the firm had $430.4 million of private equity management fee revenue. The firm’s website indicates that it has almost exactly 100 private equity investment professionals, so that’s more than $4 million in management fee revenue supporting each investment professional. For KKR, this management fee per investment professional metric has declined significantly in the last few years, as the firm has expanded into new strategies, like infrastructure investing, where it has built up significant staffing but has quite small assets. Around the time that the 2006 Fund closed, the metric would almost certainly have been close to $10 million per investment professional. Looking at the U.S. PE industry as a whole, it looks like GPs collected somewhere around $100 billion in management fee revenue in 2010, the last year for which there is good data.
The GP*s of a private equity fund don’t have to survive on just a fund’s management fee. It is actually only one of three major fee revenue streams GP*s receive, the other two being so-called “carried interest”, which is the GP*s share of profits in a fund, as well as “transaction fees” that the GP*s collect for providing “investment banking” services to the companies they own. We’ll examine both of these other fee streams in later posts devoted to each one in turn.
Finally, though management fees appear to laypeople to be “ordinary income” taxed at a top marginal rate of 35%, GP*s have found a way to have it taxed at the dramatically lower 15% long-term capital gains rate. We’ll examine this tax maneuver in great detail later on. Suffice it to say that it is very legally dubious in most instances. The industry nevertheless defends this so-called “fee waiver” with two arguments: first, that “everybody does it” (which is not true by a long shot); second, that the IRS has tacitly acquiesced to the practice by not challenging it. The IRS’ silence most likely stems from the fact that they didn’t know about the practice before now. The last week’s publicity related to Bain Capital’s use of the waiver may change that.