PE 101
How private equity firms make money
September 8, 2021
The global private equity industry consists of hundreds of firms commanding trillions of dollars in assets. With all that money at play, how exactly do these firms make their cut?
Private equity firms have access to multiple streams of revenue, many of those unique only to their industry. There are really only three ways that firms make money: management fees, carried interest and dividend recapitalizations.
Let's first take a look at how PE firms capitalize on various fees.
Management fees traditionally consist of a firm charging an LP 2% of committed capital. The fee is charged regardless of whether a firm is successful in generating a profit for investors. A $1 billion fund charging a 2% fee would land a private equity firm $20 million a year in revenue.
Management fees are the most consistent and reliable revenue stream, because they are paid annually and are easy to predict, according to Rebecca Springer, an analyst at PitchBook.
"This is why firms typically think of management fees as what 'keeps the lights on' and supports back-office staffing and the day-to-day running of the firm," Springer said.
The fees can vary greatly. Management fees can hit a floor of 1% and carried interest of 10%, according to Springer. Special circumstances vary, for example, firms will often lower management fees as a fund is winding down, since they have fewer portfolio companies and are therefore doing less work.
During an initial deal, private equity firms will often charge their portfolio companies a transactional fee worth 1% of the deal amount.
"All else being, smaller funds generate a greater proportion of their revenue from carried [interest], while larger funds generate more from management fees," Springer said.
Publicly traded firms, such as KKR, Blackstone and Apollo, have found that their shareholders highly value revenue from "fee-related earnings" and for this reason, place less emphasis on performance-based fees, according to Springer. This has, in effect, shaped the organizational strategies and new product launches of publicly traded firms.
Performance fees vary in size but can reach upward of 20% of an investment's revenue. These are awarded to a private equity firm when an agreed upon rate of return—this "hurdle rate" is typically around 8%—is hit.
The federal tax rate on carried interest is 20%, far lower than the top tax bracket of 37%. In an effort to boost investing as a whole, a federal tax provision states that carried interest be taxed at the same rate as long-term capital gains.
Critics of the tax rate often argue that billions of dollars are left untaxed annually because of the provision.
A dividend recapitalization occurs when a private equity firm takes on new debt in a portfolio company to raise money to distribute a special dividend to investors who helped fund the initial purchase of the portfolio company.
"The media often refers to dividend recaps as PE firms 'paying themselves,' but of course they're really distributing capital back to LPs and taking carry just like they would when they sell a company," Springer said. "So, when done right, a dividend recap locks in a portion of the fund's returns earlier on, which is generally a win-win for LPs and GPs."
During the process of a dividend recapitalization, a firm's equity financing is reduced, and its debt financing is heightened.
"Dividend recap activity tends to follow the overall bullishness of the market and the availability of debt," Springer said. "So right now, dividend recap activity is quite high. Firms typically will do dividend recaps of healthy companies that are generating a lot of cash and are over-equitized, meaning that they have room to take on more debt and still be at a reasonable leverage ratio."
Many firms have taken on dividend recapitalizations.
In late 2020, Blackstone issued a dividend recapitalization on Apria Healthcare, just weeks before the company held an IPO, extracting $200 million from the company in new debt to pay to shareholders.
In 2020, KKR completed a $1.9 billion dividend recapitalization with its portfolio company Epicor Software, and TPG pulled $2.6 billion in new debt out of Radiate Holdco.
Dividend recapitalizations act as the only other path for shareholders to see a return on their investment without a firm taking a portfolio company public through an IPO, known as an exit.
This page was updated on Sept. 8, 2021. An earlier version of this article was published in 2013.
Featured image by Svetlana Borovkova/Getty Images.
Private equity firms have access to multiple streams of revenue, many of those unique only to their industry. There are really only three ways that firms make money: management fees, carried interest and dividend recapitalizations.
Let's first take a look at how PE firms capitalize on various fees.
Types of private equity fees
When it comes to PE revenue, fees are its bread and butter, allowing firms essentially to keep their lights on and a key component of how private equity works.Management fees traditionally consist of a firm charging an LP 2% of committed capital. The fee is charged regardless of whether a firm is successful in generating a profit for investors. A $1 billion fund charging a 2% fee would land a private equity firm $20 million a year in revenue.
Management fees are the most consistent and reliable revenue stream, because they are paid annually and are easy to predict, according to Rebecca Springer, an analyst at PitchBook.
"This is why firms typically think of management fees as what 'keeps the lights on' and supports back-office staffing and the day-to-day running of the firm," Springer said.
The fees can vary greatly. Management fees can hit a floor of 1% and carried interest of 10%, according to Springer. Special circumstances vary, for example, firms will often lower management fees as a fund is winding down, since they have fewer portfolio companies and are therefore doing less work.
During an initial deal, private equity firms will often charge their portfolio companies a transactional fee worth 1% of the deal amount.
"All else being, smaller funds generate a greater proportion of their revenue from carried [interest], while larger funds generate more from management fees," Springer said.
What is carried interest?
By contrast, carried interest and performance fees are viewed as a way to incentivize senior-level deal professionals and align GP-LP interests, according to Springer.Publicly traded firms, such as KKR, Blackstone and Apollo, have found that their shareholders highly value revenue from "fee-related earnings" and for this reason, place less emphasis on performance-based fees, according to Springer. This has, in effect, shaped the organizational strategies and new product launches of publicly traded firms.
Performance fees vary in size but can reach upward of 20% of an investment's revenue. These are awarded to a private equity firm when an agreed upon rate of return—this "hurdle rate" is typically around 8%—is hit.
The federal tax rate on carried interest is 20%, far lower than the top tax bracket of 37%. In an effort to boost investing as a whole, a federal tax provision states that carried interest be taxed at the same rate as long-term capital gains.
Critics of the tax rate often argue that billions of dollars are left untaxed annually because of the provision.
How do dividend recaps work?
Private equity firms will sometimes take riskier routes at revenue, often through dividend recapitalizations.A dividend recapitalization occurs when a private equity firm takes on new debt in a portfolio company to raise money to distribute a special dividend to investors who helped fund the initial purchase of the portfolio company.
"The media often refers to dividend recaps as PE firms 'paying themselves,' but of course they're really distributing capital back to LPs and taking carry just like they would when they sell a company," Springer said. "So, when done right, a dividend recap locks in a portion of the fund's returns earlier on, which is generally a win-win for LPs and GPs."
During the process of a dividend recapitalization, a firm's equity financing is reduced, and its debt financing is heightened.
"Dividend recap activity tends to follow the overall bullishness of the market and the availability of debt," Springer said. "So right now, dividend recap activity is quite high. Firms typically will do dividend recaps of healthy companies that are generating a lot of cash and are over-equitized, meaning that they have room to take on more debt and still be at a reasonable leverage ratio."
Many firms have taken on dividend recapitalizations.
In late 2020, Blackstone issued a dividend recapitalization on Apria Healthcare, just weeks before the company held an IPO, extracting $200 million from the company in new debt to pay to shareholders.
In 2020, KKR completed a $1.9 billion dividend recapitalization with its portfolio company Epicor Software, and TPG pulled $2.6 billion in new debt out of Radiate Holdco.
Dividend recapitalizations act as the only other path for shareholders to see a return on their investment without a firm taking a portfolio company public through an IPO, known as an exit.
This page was updated on Sept. 8, 2021. An earlier version of this article was published in 2013.
Featured image by Svetlana Borovkova/Getty Images.
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