By Anthony Parrish
Private equity used to be a niche area of finance mostly centered around leverage buyouts. As the New York Times noted in a recent article covering the spread of private equity firms, “[they] were once niche players serving big clients. Now they are trying to be everything to everyone.”
There’s certainly truth to that statement: There is a private equity-backed token in the world of blockchain, cryptocurrencies and decentralized finance (DeFi), and sports team ownership/investment is just another opportunity for finding strong returns. With so many opportunities for private equity, it is no surprise that the White House is taking a closer look at the industry.
Welcome back to Meeting Your Prospects in Private Equity (Part 2 of 2: cramming an industry into two articles)! When we left off, we covered the basics: What is private equity? What is compensation like at a private equity firm? What sources are there for employee compensation? Return to “Meeting Your Prospects in Private Equity (Part 1 of 2)” if you want a quick refresher.
Here we’ll move on to the major players: the partners. Sometimes known as managing directors and a myriad of other terms, partners are often the prospects involved in private equity with the greatest capacity. Their wealth may be highly dependent on the firms’ activity and investment success, but as you will see below, the baseline compensation can be substantial.
So, let’s get to it: a straightforward estimate for partner compensation…
2 and 20: Estimating Partner Compensation in Private Equity
Let’s say you have a new prospect that is a partner at Example 1 LLC, a private equity firm. The simplified rule of thumb is that partners could earn compensation from A) the 2% management fee the firm charged clients, and B) a 20% carried interest/performance fee paid when the fund is doing well (and hitting certain benchmarks). (Hence, “2 and 20.”)
Here is what that could look like outside a formula:
Example 1 LLC is a global private equity firm with 50 partners and $10 billion in assets under management. They charge a 2% management fee and a 20% share of the return.
You could assume that partners would have an average annualized compensation from the management fees of $4 million. But that would be forgetting that Example 1 LLC also has a bunch of other costs: overhead. These might be tax-related expenses, legal fees, operational costs, etc. For the sake of simplicity, let’s use 50%. The average annualized compensation from management fees is now $2 million.
Side note: Overhead is a whole other topic that we are not getting into today, but generally something in the range of 20-50% when thinking about private equity firms’ potential overhead costs. I have yet to find a great standard for this because there is so much variability between firms in terms of size and types of investment. When making your own calculations, work out a couple of different variations and find what makes the most sense in the context of your prospect’s firm.
Returning to Example 1 LLC, we know that the partner’s compensation also comes from a 20% share of profits; but what are the profits? The short answer to this is that we do not know. Unless you find documentation showing a firm’s rate of return, you will have to make a generalization or assumption. We’ll get more into this, but for now let’s use 10%. That gives us $4 million in average annualized compensation from performance, bringing total annualized compensation for the partner at Example 1 LLC to $6 million.
I know there are some issues we’ll need to address here (return rates, how this varies, etc.) but before that, let’s run through a couple more firms to provide a bit of context:
Example 2 LLC is a small private equity firm with three partners and $100 million assets under management. They charge a 2% management fee (40% overhead), and a 20% share of return (10% rate of return).
This firm’s partners would have an average compensation from management fees of and an average annualized compensation from share of profits of approximately $666 thousand . It seems straightforward, right? Let’s do one more…
Example 3 LLC is a small private equity firm that spun off from a big-name firm; the five partners involved attracted a lot of capital with $750 million assets under management. They have a variable management fee from 1% to 2% depending on their clients’ investment size (40% overhead), and a 20% share of return (10% rate of return).
The first thing you probably noticed is that the management fee rate is a range instead of a set number. This is common and a way for firms to incentivize greater investments in their fund from their clients. To find a firm’s specific management fee and what rules they might have around fee ranges, you will probably need to dig into the firm’s filings on the U.S. Securities and Exchange Commission’s Investment Adviser Public Disclosure website. We’ll get to that later, but for now let’s err on the conservative side of a compensation estimate and use 1%.
Example 3 LLC’s partners would have an average compensation from management fees of $900 thousand and an average annualized compensation from share of profits of $3.9 million.
If you have not thought of it already, I highly recommend building a widget on your favorite spreadsheet software that lets you do these calculations quickly and allows you to adjust the variables (number of partners, assets under management, rate of return, etc.).
The concept of “2 and 20” does come with a couple of caveats. One of the most important to remember is that the “20” comes from the performance of investments. This means that even if a firm performs well every year, there will be significant variability year-to-year in performance-based compensation. Private equity is a long-term investment as funds are measured over years, so take any estimates using the above formulae with a grain of salt. You are not calculating the paycheck, but rather getting an estimate that you can use to understand a prospect’s capacity over the course of several years.
The second caveat is that “2 and 20” is not as straightforward as it seems. Specifically, in years where the fund loses money or fails to meet certain performance thresholds, the partners may not make any performance-based compensation. There are also often return thresholds that must be hit before any performance fees are assessed, and performance fees may come from only the portion above the thresholds.
If you really want to understand the way compensation works, I’d suggest working your way through some of these articles that cover hedge fund and private equity performance fees:
- Two and Twenty from Investopedia
- 2 and 20 (Hedge Fund Fees) from the Corporate Finance Institute
- What is ‘Two and Twenty’? from The Balance
- The Performance of Hedge Fund Performance Fees by Itzhak Ben-David and Justin Birru of Ohio State University and Andrea Rossi of University of Arizona (this paper is great if you want to delve into how these fees actually affect investors)
The main reason I have presented a simplified version of “2 and 20” is because to use all the variables in performance fee structures, you would need to know way more about the fund than is typically available.
Through all those examples, we used arbitrary numbers to fill in parts of the equations… But where can you find information about your prospect’s specific firm?
Form ADV: A Wealth of Information
Where To Find It
Information about private equity firms is scarce. Many private equity firms have minimal web presences, some eschewing public-facing domains entirely. Websites that do exist are primarily there and often function as a starting point for investors, so statements made tend to be broad, positive and enticing. There are third-party sources of information around private equity such as PitchBook, Preqin, Private Equity Info, Crunchbase, Mergr, Private Equity International and many more, but most do not delve into compensation or the weeds of a particular firm’s fees structure.
The best place to find detailed information on a private equity firm (at least in the United States) is the Investment Adviser Public Disclosure website from the SEC. The Firm tab of this website is searchable (by firm name or by location) and gives free access to Form ADV filings by firms managing $25 million and up.
What’s In a Form ADV
First a disclaimer: I do not promise to cover every aspect of Form ADV, I only promise to get you started on the path of doing your own research. Each firm is unique, and there are variances within its filings. For more detail, check the SEC’s FAQ page, read through the form itself, or attend NEDRA’s High Finance for Prospect Researchers: Private Equity and Hedge Funds the next time that they offer it.
For now, let’s talk through where to find the various variables from the formulae earlier and where you can find those numbers.
Number of Partners:
One place to look for this is the firm’s website. Within the Form ADV, however, you will want to look at Schedules A, B, C, and R. Schedule A identifies direct owners of the firm and executive officers too and includes useful information such as the starting date of their status with the firm and even ownership information (including ownership percentage ranges). Schedule B does the same but for indirect owners. Schedule C updates information from Schedules A and B. And many times, the same information is available on Schedule R, Section 4. (Schedule R is specifically about relying advisors but can be duplicative depending on the firms structure; there are a host of ways firms structure themselves, and each can mean slight differences in reporting requirements.).
The big caveat around using these schedules is that they do not always list everyone who would be getting partner-level compensation but focus on owners. And more importantly, the “owner” might just be another LLC or other entity and is then subsequently owned by the partners. (You can sometimes follow this trail through sites like OpenCorporates.)
After you look at these ownership sections, check out Part 1A, Item 5; this section includes a question about employees (full- and part-time, not including clerical workers). That can really help you get a handle on the size of the firm.
Assets Under Management (AUM):
If you’re playing along at home, you probably noticed that this Part 1A, Item 5 also includes a question about regulatory assets under management, which is a great place to find the firms’ AUM. (For those interested in the due diligence side of things, note this same area gives you an idea of how many clients are from the U.S. versus international. Form ADVs can be a major source for due diligence, but that’s a different topic…)
The other area you will want to explore is Section 7.B Private Fund Reporting. Here, you’ll get a lot more granularity as how the money is allocated by fund. If you happen to know that a particular prospect is a lead on a certain fund at a big firm, this could help give you a sense of scale for their work. If you add up all the funds, you typically will get a similar (if not the same) number as the AUM. Some variances occur for a variety of quirks in fund reporting. At smaller firms, this section might just have one or two funds, while at larger firms it can get lengthy.
Management Fees and Performance Fees/Share of Return:
For those pesky percentages that really matter for compensation calculation, you will need to move over to the firm’s Part 2 Brochures. These typically include a section dedicated to fees and compensation and a section dedicated to performance-based fees. The downside to Part 2 Brochures is that they are typically written in prose, with a fair amount of legalese. These documents also have a slew of other sections with more information about the firm, their investments, etc. and can be handy to dig into when looking very closely at a particular private equity firm.
Before we talk about what is not in the filings, I should also mention that these aren’t always 100% up to date. There is a slight delay from when the company files documents to when those filings are updated on the SEC’s website. In some cases, you may also have trouble finding a firm because their legal name is different from their business name. For some larger or global firms, there might be multiple filings with different subsidiaries of the same overarching firm. As mentioned before, each firm will be a little different.
What’s Not in It: Rate of Returns
We’ve covered most of the variables from the compensation formulas, but one that sticks out like a sore thumb is the rate of return that is used to determine performance-based compensation. (Earlier I used 10% as a placeholder.). Each firm, and each fund at each firm, is going to be different. To be frank, you will not get an exact percentage to add in here unless you are an investor with the firm in question. That said, there are some resources for giving your best guess.
Option 1: Do not base your compensation estimates on performance-based gains unless you have a solid reason to believe the firm is doing well. You could find evidence of this through deals that are completed by the firm, or a news article that gives specific numbers to a firm’s performance each year. You will still have the management fee-based compensation to run with for your capacity estimates.
Option 2: Private equity are alternative investments and sometimes have incredible gains, but I want to be very conservative and align my estimate with public equity (stock markets). I personally don’t think this is a great option, but you could peg your numbers to historic returns from stocks: approximately 7-8% (per SEC Guide to Savings and Investing). The problem is that this is not representative of the private equity market, and certainly doesn’t represent the firm you’re looking at.
Option 3: Dig into benchmark return rates as provided by PitchBook (free on their Reports page), Preqin (with a free account here), or another source. My personal preference is the PitchBook benchmarks because you can look at private equity on a global scale, or drill down by geography, fund starting year or AUM size. The report comes out on a quarterly basis so you can get current numbers.
Thanks to the popularity of private equity, more of this information is becoming publicly available. CalPERS even provides an overview of funds that it has invested in with return rates included and notes its net IRR is 11.5%.
Estimates and ranges are so important when evaluating private equity. Even with formulae, you’ll want to run different variations to see what compensation might look like in different years, with different levels of fund performance.
Caveats and Why Estimates Are Your Friends
The other aspect not covered in Form ADVs that you might have caught is how to understand ownership of a private equity firm. This is a whole other topic and likely better suited to a conversation around business valuation. Sometimes you might get lucky and find a valuation of an ownership stake through a news article or other third-party source (Wealth-X sometimes includes such information), but not often.
Now It’s Your Turn
Are you ready to tackle your prospects in private equity? It’s time to get ready because this area does not seem to be going away anytime soon. In 2020, Institutional Investor noted that assets under management in private equity could surpass $9 trillion (yes, trillion) by 2025. Someone’s prospects are going to be working with that capital. Will it be yours?
Would you like Apra Connections to cover a specific aspect of your prospects’ capacity? Do you want to share your insights in another industry? Are you frustrated I suggested using a spreadsheet but did not share my own setup? Are you interested in connecting and grabbing a virtual tea to talk shop? You can reach me at firstname.lastname@example.org.