Private Equity

Fees: two and twenty

Firms are typically paid in two ways. A management fee, often around two percent of committed capital a year, covers salaries and running the firm. Carried interest, typically around twenty percent of the profits, is the real prize, but the firm only earns it after investors have received their capital back plus a minimum preferred return, known as the hurdle. That order of payout is called the waterfall, and it is what ties the firm reward to the fund actually performing.

The fund lifecycle

Career timeline

How long each step takes

Private equity does not follow one fixed ladder, and the timing depends on the firm, the country and how you join. As a rough guide, the path from your first year to partner tends to look like this.

Only some firms, mostly the larger ones, hire analysts straight from university, and an analyst usually spends about two years in the role before moving up or leaving for an MBA. The more common entry point is the associate level, which people often reach after around two years in investment banking or consulting. An associate program itself typically runs two to three years.

From there, a vice president usually spends around three to four years leading deal teams, and a principal or director a similar three to four years, shifting from doing the analysis to sourcing and negotiating deals.

Reaching partner or managing director, the top of the firm, usually takes ten or more years in the industry. In practice many people step off the ladder along the way, for an MBA, a move into a portfolio company or a switch to another fund, so few careers follow it exactly.

The business

How private equity firms make money

A private equity firm raises money from investors and pools it into a fund. Those investors, the limited partners, are usually pension funds, insurers and wealthy individuals. The firm acts as the general partner: it manages the fund, chooses the investments and steers the companies it buys.

Most firms earn money through a model often called two and twenty. They charge a yearly management fee of around two percent of the money they manage, which pays for salaries, offices and running the fund. On top of that they keep about twenty percent of the profit the fund makes, but only after investors have earned back their money plus an agreed minimum return.

The management fee is steady and does not depend on how the investments perform. The profit share, called carried interest, only pays out when the fund does well. Some firms also charge the companies they own separate transaction fees for buying them and monitoring fees for advising them.

The firm makes its biggest gains when it sells a company for more than it paid. If the sale clears the agreed threshold, the firm receives its share of the profit, and that is where most of the real money is made.

Carried interest

Carried interest, the senior payoff

Carried interest is the share of a fund's profit that goes to the private equity team, usually around twenty percent of the gains. At junior levels it plays little or no role, but higher up it can become the largest part of someone's pay and, in a strong fund, run into the millions.

It is earned over time and often paid out only years later, once the fund has done well enough. In a whole-fund model, the team receives nothing until investors have recovered their money plus the agreed minimum return. In a deal-by-deal model, shares can be paid earlier, per successful deal, which is why funds often add a clawback so investors can be repaid if later deals disappoint.

How the payout works

The payout does not happen all at once. When a fund sells a company, or several, the cash flows through a fixed order of priority known as the distribution waterfall, rather than being split as soon as a profit appears.

Investors are repaid first: every euro of capital they contributed comes back before anyone else is paid. Only once that capital is returned in full do investors receive their preferred return, an agreed minimum profit, sometimes called the hurdle rate, that has to be cleared before the firm earns anything at all.

After the preferred return is paid, the firm receives a catch-up, a slice of the remaining profit that brings its share up to its full carry percentage. Once the catch-up is complete, any further profit is split between investors and the firm at that same fixed ratio, so the firm's share of the gains stays constant no matter how large the fund's eventual return turns out to be.

Because carried interest is calculated on the fund's entire profit and then divided among the partners and senior investors according to each person's individual allocation, even a modest carry allocation can become valuable in a fund that performs well, which is a large part of why it is used to retain senior people.