PRIVATE MARKET INSIGHTS FUNDAMENTALS HOW DO PRIVATE MARKET FUND FEES WORK?
Private market funds charge two types of fees: a management fee and a performance fee. These are both generally taken out of an investor’s capital balance, rather than paid via invoice or capital call.
MANAGEMENT FEE > Designed to meet the routine operational expenses a fund manager accrues in actively managing a portfolio, including salaries, rent, and regulatory compliance costs, among others. > Typically levied annually as a percentage of an investor’s committed capital, though some structures may charge a fee based upon called capital. Committed capital is the money an investor has agreed to invest in a fund across its entire lifespan. Called capital is the money called up by the fund manager to make investments. > Management fees tend to range from 1% to 2.5% of committed capital during a fund’s investment period, which is typically three to five years. Thereafter, this fee is usually substantially reduced.
PERFORMANCE FEE > Also referred to as carried interest or just carry, the performance fee is a share of profits If an investment does earned by the investment manager. not return above the > Historically this profit share has been roughly 20%, and in an ideal investment scenario hurdle rate, the manager is where the manager earns most of its money. does not receive any > Almost all private funds, however, include what is referred to as a hurdle rate, or preferred carried interest. return (see below). This rate of return, typically about 8%, accrues annually, and is the level below which the manager does not earn a performance fee. The interests of the manager and investor are therefore strongly aligned.
> CHART 1: Illustration of compounding hurdle rate/preferred return 8% hurdle rate on investment, compounding annually
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Source: Family Capital (https://www.famcap.com/2018/10/private-equity-fees-and-waterfalls-on-direct-deals/) Private Market INSIGHTS
CATCH-UPS AND THE DISTRIBUTION WATERFALL Many funds are set up so that once 100% of invested capital has been returned to the investor – including fees and expenses – and the hurdle rate has been met, the manager is entitled to receive a “catch-up”. This is capital equal to the carried interest the manager would have received had it not applied a hurdle rate to returns. In other words, if the manager beats the hurdle rate it effectively disappears, and the overall split of fund returns is as per the carried interest agreed upon. This catch-up phase is one element of what is referred to as the distribution waterfall, which denotes the sequence of distributions to investors and the manager.
> CHART 2: The distribution waterfall and performance fees
Sequence of distributions from a private market fund with a catch-up agreement
Investment distributions
2) Preferred return/hurdle rate 1) Return of initial capital All returns go toi investors until the manager 100% to investor All returns go to investors achieves the agreed preferred return
3) Catch-up 100% to manager Fund manager receives cash equal to the carried interest it would have received had it not applied a hurdle
4) Carried interest Divided per agreed The manager receives an agreed upon share of distributions (carried carried interest interest) as a performance fee
Source: HarbourVest. For illustrative purposes only. Private Market INSIGHTS
> CHART 3: Illustration of performance fee application for a hypothetical $1 investment
A $1 investment, exited after 5 years. 8% hurdle rate, 20% carried interest.
Successful investment, above hurdle rate Less successful investment, at hurdle rate 4x initial investment value ($1 to $4) 1.47x initial investment value ($1 to $1.47) Cumulative distributions Cumulative distributions To investors To manager To investors To manager Cash for distributions $4 $1.47 Return of initial capital $1 $1 Remaining distributions $3 $0.47 5 years @ 5 years @ 8% hurdle 8% hurdle Preferred +$0.47 +$0.47 return/ hurdle rate $1.47 $1.47 Remaining distributions $2.53 $0 +$0.12* Catch-up No performance fees apply $0.12 If an investment does not return Remaining $2.41 distributions above the hurdle rate, the manager does not receive any 80% of 20% of carried interest. remaining remaining Carried distributions distributions interest +$1.93 +$0.48 * $0.47 x 20%/80%.
$3.40 $0.60 Calculation: Total hurdle payment x (manager’s carried interest rate / investor’s profit interest)
Source: HarbourVest, Family Capital (https://www.famcap.com/2018/10/private-equity-fees-and-waterfalls-on-direct-deals/). This is intended to be a purely illustrative example of how and when performance fees are applied in a private market fund. It does not include details of all fees that may apply when investing. It should be used solely as a guide and should not be relied upon to make investment decisions.
For a broader introduction to private market investing, please view our primer: Investing in The Private Markets: Focusing on the Fundamentals.
For more information on private market funds, and how HarbourVest may be able to help you achieve your investment goals, please get in touch with your HarbourVest contact or email [email protected].