The formulas, tricks and trade secrets of Private Equity

Private Equity Fees

Sample Chapter

Common belief of private equity investments is that the bulk of the return comes from an exit event. We all know that part of the return may come from secondary sources, but the real upside seems determined by the value of the exit. This is true… to some extent.

Private equiteers often insist on investing via preferred equity, which includes a preferred coupon (see the post for info on preferred equity). The preferred coupon creates a return on the investment prior to the exit event; so, if there are any issues with the exit or the company sinks, the cumulative preferred coupons can help soften the blow. Some coupons are so high that they pay back the original investment before an exit occurs.

Another way to create a return is through management private equity fees. The fees are charged to investees for helping to manage them. These private equity fees are usually in addition to preferred coupons and can represent millions of dollars a year. The case put forward to the founders, or other investors, is that the private equiteers need to be paid a pseudo-salary for their ongoing work. This may also encompass board fees if they aren’t stipulated separately.

Let’s try an example. I invest $10m into a business as preferred equity with a 12% coupon and management fees of $0.25m per quarter. Therefore, I receive $2.2m per year from the coupon and private equity fees combined. Add to that an initial signup fee of $0.5m and acquisition fees over the life of the investment of $1m. In the first year, the return is $2.7m; second year, the cumulative return is $4.9m; third year, $7.1m; and the last year, $9.3m, plus total acquisition fees of $1m, and we have $10.3m returned before we’ve even exited the investment. Plus there are any ordinary dividends earned along the way, depending on the terms.

Compared to ordinary dividends, preferred coupons and management fees shift the return away from other investors (since they aren’t participating in these terms). If things fall to pieces in say year three of my example, the private equiteer has received approx $7m of the original $10m investment back. If there were no coupon or private equity fees, the entire $10m would have vanished. It’s a form of risk mitigation.

Like many components of a private equity deal, this may seem a little unfair… okay, very unfair. But, as I’ve discussed many times, a private equity investment must be viewed with all of the terms in mind. There’s no denying that private equiteers drive hard bargains, and that founders in the past have resented such deals, but we’re all consenting adults. In many cases, aggressive terms such as high fees offset an unusually high valuation. Often founders, and especially their merchant bankers (whom receive a commission based on the top-line price), prefer higher top-line multiples.

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