SSRN Id2466566

OUP-FIRST UNCORRECTED PROOF, March 6, 2015
20
Compensation Structure
JI-WOONG CHUNG
Assistant Professor, Korea University Business School
Introduction
A private equity (PE) fund usually lasts for about 10 years and is typically organized as a
limited partnership in which fund managers serve as general partners (GPs) and investors
are limited partners (LPs). GPs are responsible for the fund’s daily management and are
personally liable for the partnership’s debts and obligations, although they usually avoid
unlimited liability by forming a general partnership through a limited liability company
(LLC). By contrast, LPs have limited liability and do not participate in managing the part-
nership. Inherently, the GP–LP relationship suffers from agency problems because LPs
cannot closely monitor GPs’ activities. Therefore, the limited partnership agreements
(LPAs) stipulate various conditions to align the interests of GPs and LPs by specifying
covenants, the financing processes, and fee structures. This chapter examines PE fund fee
structure and explores how different fee structures may create different incentives for GPs.
The standard compensation structure of PE funds is known as “2-and-20,” where the
“2” refers to a management fee of 2 percent of committed capital and the “20” refers to a
GP’s carried interest of 20 percent of profits. This structure, including substantial carried
interest that greatly exceeds the usual pay-for-performance sensitivity of chief executive
officers (CEOs) of publicly traded corporations, is a key driver of PE funds’ success
(Frydman and Jenter 2010).
The actual compensation structure of PE funds is much more subtle and complex
than the 2-and-20 rule implies. Different LPAs specify different rules for how to cal-
culate, when to recognize, and how to split profits and so forth. Many of these detailed
fund terms are open to intense negotiation between GPs and LPs. The expected size of
GP compensation and the effective incentives of GPs vary substantially across funds
depending on how fund terms are arranged and written.
The rest of chapter is organized as follows. The next section explains the structure of
different types of fees that GPs earn, variations of the basic fee structure, and incentive
outcomes of different fee arrangements. Next, the chapter surveys the academic litera-
ture about PE compensation structure and discusses such issues as whether fees gener-
ate enough pay-for-performance for GPs, how fund and market characteristics relate to
fee structure, and how the bargaining power between GPs and LPs alter compensation
practices in the PE industry. The final section provides a summary and conclusions.
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C om pe n s at ion S t ru ct u re 361
Compensation Structure of PE Funds

This section reviews three major components of PE compensation: (1) management
fees, (2) carried interest, and (3) deal-level fees. The section discusses the basic struc-
ture as well as the variation of each fee component. It also shows how to compute each
fee, and how GPs’ and LPs’ interests can be misaligned under particular forms of fee
terms.
M a n a gemen t F ees
LPs pay an annual management fee that is a percentage of the amount invested by the
LP. Management fees cover the ongoing operating expenses of the partnership such as
the salaries of the investment team, rents, and other costs associated with investment
activities. As implied in formulating the management fee, the absolute dollar amount of
the fee is higher for larger funds based on an assumption that greater required resources
are necessary to manage those funds.
The annual management fee percentage usually falls between 1 and 3 percent and is
paid on a quarterly, semi-annual, or annual basis in advance. The fee basis could be (1)
committed capital, (2) a combination of uncalled committed capital and cost basis of
ongoing investments, (3) net invested capital, or (4) net asset value (NAV). The first
two bases usually are used in the fund’s earlier life.
The fee percentage is either fixed or variable throughout a fund’s lifetime. In a
variable management fee, a fund reduces its fee level from its initial level after the
investment period, which is generally the first five years of the fund’s life. The fee
percentage also decreases with the increased fund size on the ground that econo-
mies of scale exist in managing the fund. The fee percentage also may be reduced
when a follow-on fund (new fund) is raised based on the view that a part of the
fixed overhead will not rise simply because a new fund is formed. For example, a
partnership does not necessarily need extra office space to manage an additional
fund.
LPs committing a larger amount of capital could have more favorable fee arrange-
ments by paying a lower management fee percentage. Thus, different investors in the
same fund may pay different fee percentages. Further, PE funds that do not require
greater oversight and management resources demand a smaller management fee per-
centage. For example, buyout (BO) funds, on average, charge a lower fee percentage
than venture capital (VC) funds, and funds-of-funds do not charge as high a fee as regu-
lar PE funds.
PE funds sometimes specify a different fee percentage depending on the aggregate
amount of the fund to be raised. For example, the fee could be set at 2 percent if com-
mitted capital is below $1 billion and 1.5 percent otherwise. Management fees are typi-
cally paid out of committed capital in the early years of the fund or the proceeds from
investments in later years of the fund. However, management fees could be paid to GPs
apart from the stated committed capital. The latter is especially useful when different
investors pay different fee percentages, in which case computing profit-sharing among
LPs becomes challenging.

362 p r i vat e e q u i t y : u s e s a n d s t r u c t u r e
The fee basis can also be variable. It is typically based on committed capital or a
combination of uncalled committed capital and the cost basis of unrealized investments
during the five-year investment period. Then it switches to net invested capital, which is
the cost basis of all investments minus the cost basis of realized investments (i.e., the
cost basis of ongoing investments). The rationale is that management fees compensate
for the cost associated with continuing to operate a fund. This cost tends to fall in later
years of the fund’s life when GPs mainly focus on harvesting existing investments via
sales, public offerings, or bankruptcy, which is a period when arguably less effort is
required.
PE funds could introduce a budget-based management fee in which GPs periodically
present their planned budget for operating expenses and get approval from LPs or the
representatives of LPs at annual meetings. However, the drawbacks of this approach are
the added costs associated with budget planning and the concern for sharing sensitive
financial information with outsiders.
LPs should understand the possibility that a different fee basis can cause different
incentives for GPs at the expense of LPs. For instance, when committed capital is the
basis, GPs have an incentive to raise larger, perhaps excessively large, funds, which might
erode future fund performance by paying GPs even during the divestment period when
no investment activity exists.
The management fee as a percentage of uncalled committed capital and the cost basis
of unrealized investments can be used as a basis. This approach excludes the cost basis
of exited investments from the fee basis based on the assumption that monitoring and
investment-related activities is no longer needed for these liquidated investments. Al-
though they may not be materially large if a portion of capital contribution is used to pay
for expenses (e.g., fees), LPs effectively pay a fee on fees.
Net invested capital better reflects the intensity of investment and monitoring activi-
ties by GPs. However, net invested capital is rarely used as a management fee basis in
the early years of a fund’s life because the partnership does not usually have sufficient
monetary resources to support investing activities during this period when net invested
capital is minimal. Using net invested capital as a fee basis in later years could incentiv-
ize GPs to delay realizing poor investments as late as possible to maximize net invested
capital and related fees (Robinson and Sensoy 2013).
Although funds used NAV as a fee basis in the early 1980s, this practice has virtually
disappeared in the BO and VC industries. NAV is the estimated market value of ongo-
ing portfolio companies (i.e., companies owned by the partnership). Since GPs perform
the NAV valuation, they could overestimate the value of portfolio companies to boost
their fee revenue or to influence future fund raisings (Barber and Yasuda 2013; Brown,
Gredil, and Kaplan 2014).
The LPs should be aware of the incentive effects of the management fee structure. They
negotiate the terms of the contract with GPs in order to better align the interests of GPs
with themselves and yet provide reasonable income to the GPs. Clearly, tension exists be-
tween the LPs and the GPs on the terms of management fee. Excessive fees threaten the
relationship between the LPs and the GPs especially when the expected management fees
are greater than the expected carried interest (performance-based revenue). Conversely,
reasonably low fees can demotivate the GPs by distracting them from focusing on operat-
ing the fund and hampering the GPs from attracting talented investment managers.

C a r r ie d I n t e r es t
Carried interest, which is also called carry, promote, or override, is the GP’s share of the
profits from a PE fund. Carry is a performance-based fee to align the interests of LPs
and GPs. This fee structure generates high-powered pay-for-performance for GPs and is
the key driver of success of PE funds. Most PE partnership agreements stipulate a car-
ried interest of 20 percent. In fact, Robinson and Sensoy (2013) report that more than
90 percent of PE funds choose a 20 percent carry. Similar to management fees, carried
interest is lower for fund-of-funds than regular funds and BO funds than VC funds.
Calculating carried interest is complex and involves intense negotiation between LPs
and GPs. Indeed, profit distribution methods and carried interest calculations rank as
the most important provisions in LPAs by LPs and GPs (Tuck 2004).
The implicit amount of incentives provided to GPs varies substantially across funds
depending on the detailed terms of carried interest including the size, timing, and cal-
culation method of carried interest. Partnerships should determine how to calculate
profits, when to recognize profits, and how to split the profits between LPs and GPs.
Partnership agreements that spell out the rules governing payment priorities among
partners are known as waterfall provisions.
When computing profits, one problem is how to treat management fees, organiza-
tional expenses, and other income or expenses. Partners must decide whether these fees
and expenses should be paid by the fund and whether the fund’s profits should net these
fees and expenses when calculating carried interest. Organizational expenses are the costs
associated with raising and forming the fund. Other income or expenses include inter-
est on short-term investments, dividends from portfolio companies, litigation expenses,
the costs of annual meetings, and deal-level fees such as transaction fees, monitoring
fees, and break-up fees. A later section provides a detailed discussion of these fees.
Consider a simple example of a fund with a committed capital of $100 million, an
annual management fee of 2 percent of committed capital, and a one year life. Over the
life of the fund, total management fees amount to $2 million. The partnership must first
decide whether these fees are paid out of the committed capital or separately by the LPs
and whether shared profits are based on $98 million (i.e., invested capital net of fees) or
$100 million (contributed capital). In the latter case, the GPs must first recoup manage-
ment fees before they share profits.
Often LPs receive a minimum rate of return before GPs start receiving carried interest,
which occurs more so in BO than VC funds. This threshold return is called a preferred return,
which is typically 8 percent per year. In other words, if a fund does not produce more than
8 percent annual return, the GPs do not receive carried interest. This pure preferred return
may come with a catch-up provision, usually called the hurdle rate. BO fund agreements
almost always include a preferred return term while VC funds rarely do so (Fleischer 2005).
Several issues must be considered when a partnership specifies a preferred return
and a hurdle rate. For example, the following questions should be addressed and clari-
fied in the partnership agreement: Should the preferred return be compounded? If so,
how frequently? Does the preferred return accrues to all contributed capital (including
fees and expenses borne by the fund) or invested capital only (capital used for invest-
ments)? Should a partnership have multiple hurdle rates? Schell (2005) and Breslow
(2009) provide more discussion about detailed contractual terms of preferred returns.

A catch-up provision allows GPs to quickly recover their carried interest after a pre-
ferred return is delivered to LPs. The recovery speed varies depending on the catch-up
allocation rule. A 100 percent catch-up provision allows GPs to recover 100 percent of
the agreed-upon carried interest of the cumulative profits before sharing the profits with
LPs, according to the carry provision (e.g., an 80/20 split).
An example can help explain the exact mechanism of the catch-up provision. Con-
sider a fund with a 20 percent carried interest and a hurdle rate of 8 percent. The com-
mitted capital is $100 million, and the entire amount is invested on the first day of its
operation. The investment is sold for $130 million in one year, and the fund is liquidated
on that day (i.e., the internal rate of return (IRR) equals 30 percent). Figure 20.1 shows
the profit distribution of $30 million between LPs and GPs. This chapter considers two
scenarios for the catch-up provision.
The first scenario involves a 100 percent catch-up provision. The LPs first recoup the in-
vested capital of $100 million. They also receive 8 percent (the hurdle rate) of the invested
capital (i.e., $8 million). Next, the GPs receive 100 percent of profits until they receive 20
percent of the cumulative profits. Since the $8 million that the LPs recover represents 80
percent of the cumulative profits, the (corresponding) cumulative profits are $10 million
(i.e., $8 million/0.80). Therefore, the GPs receive 20 percent of the $10 million, which is
$2 million. The remaining profits, $20 million (= $30 million – $8 million – $2 million),
are allocated 80 percent to the LPs ($16 million) and 20 percent to the GPs ($4 million).
In sum, the GPs earn 20 percent of the total profits ($2 million + $4 million = $6 million =
0.20 [$30 million]) and the LPs 80 percent ($8 million + $16 million = $24 million = 0.80
[$30 million]) of the total profits, $30 million.
The second scenario involves a 50 percent catch-up provision. As in the first sce-
nario, the LPs collect the first $8 million. The GPs receive 50 percent of the profits until
they receive 20 percent of the cumulative profits. If $x is the incremental profit (over $8
million), then the cumulative profits are $8 million plus $x. Thus, $x would be deter-
mined algebraically as shown in Equation 20.1:
0.50($x) = 0.20($8 million + $x) (20.1)
The 50 percent of the incremental profits that the GPs receive should equal 20
percent of the cumulative profits. Therefore, $x = $5.33 million. Hence, for the next
$5.33 million in profit, the GPs and the LPs are allocated $2.67 million (= $5.33
[0.50]) each. The remaining profits, $16.67 million (= $30 million – $8 million –
$2.67 million – $2.67 million), are allocated 80 percent to the LPs ($13.33 million)
and 20 percent to the GPs ($3.33 million). Therefore, the GPs earn 20 percent of the
total profits ($2.67 million + $3.33 million = $6 million = 0.20 [$30 million]) and the
LPs earn 80 percent ($8 million + $2.67 million + $13.33 = $24 million = 0.80 [$30
million]) of the total profits of $30 million. Figure 20.1 shows the final split of the
profits between GPs and LPs.
In these examples, both catch-up allocation rules (100 percent and 50 percent)
result in the same profit-sharing between the LPs and the GPs because the fund gener-
ates sufficiently high profits. However, as Figure 20.1 shows, when profits are not high
enough, different catch-up allocation rules will generate different allocation outcomes

Case 1. 100% Catch-up Provision
80—20 split
$16 m
$4 m
Catch-up 100%
$2 m
Hurdle rate
$8 m
Committed
capital
$100 m
LP GP
Case 2.50% Catch-up Provision
80—20 split
$13.33 m
Catch-up 50% $3.33 m
$2.67 m $2.67 m
Hurdle rate
$8 m
Committed
capital
$100 m
LP GP
Figure 20.1 Illustration of Profit-Sharing between Limited Partners and

General Partners This figure considers a fund with a 20 percent carried interest and
a hurdle rate of 8 percent. The committed capital is $100 million and the whole amount
is invested on the first day of its operation. The investment is sold for $130 million in one
year and the fund is liquidated on that day. The distribution of the profits of $30 million is
shown.
for the partners. Specifically, if the cumulative profits are between $8 million and $13.33
million in the example, the two allocation rules yield different allocation of profits to the
LPs and the GPs. Without a catch-up provision, the GPs effectively receive less than a
specified (e.g., 20 percent) carried interest.
Another important issue involves when to recognize and distribute profits. Two
types of waterfall provisions are available: (1) American style, which is also known as

deal-by-deal or front-end-loaded distribution, and (2) European style, which is also

known as aggregation method or back-end-loaded distribution.
American style waterfall computes and shares profits on a deal-by-deal basis. Al-
though popular in the infancy of the PE industry, especially in the United States, the
pure form of American style waterfall has become less popular in recent years, as this
waterfall structure overly favors GPs.
In American style waterfall, profits are computed for each portfolio investment. If
profits are earned, GPs share a pre-specified carry after taking into account, if any, a
preferred return or hurdle rate. However, if losses occur, only LPs bear the losses. The
economic interests of LPs and GPs can be misaligned. GPs have a convex compensation
structure as a call option and, all else being equal, have an incentive to increase the risk
in portfolio investments at the expense of LPs.
A deal-by-deal carry may come with a loss carry forward provision to mitigate this
problem in which carry is computed after considering the losses incurred in the previ-
ous investments. For example, suppose the GPs make two investments with the cost
basis of $10 million each and a 20 percent carry on a deal-by-deal basis. The first invest-
ment generates a $5 million loss and the second one earns a $5 million profit. Without
a loss carry forward provision, GPs would receive zero carry in the first deal and a $1
million (= 0.20 [$5 million]) carry in the second deal. However, with a loss carry for-
ward, the loss of $5 million from the first deal will carry forward and net out the profit of
$5 million in the second deal. Hence, the GPs will not share the profit from the second
deal. This example ignores the time value of money.
Another mechanism to alleviate over-paying carry to GPs is to include a clawback
clause in LPAs. A clawback clause allows LPs to “collect back” overpaid carry from the
GPs at the end of a fund’s life although interim clawback clauses can be set up. However,
several issues arise in executing a clawback provision such as when to turn on a clawback
and how to make sure LPs receive overpaid fees.
Suppose a fund manager makes two investments simultaneously, each costing $100
million. The first portfolio is liquidated at $130 million in one year, and the second one
is divested at $80 million in two years. The carry is 20 percent and the hurdle rate is
8 percent per year with a 100 percent catch-up. The first divestment results in a $30
million profit and an IRR of 30 percent. The LPs receive the invested capital ($100 mil-
lion) plus an 8 percent preferred return ($8 million). The GPs then receive 100 percent
catch-up on the next profits until they recoup 20 percent of the cumulative profit (i.e.,
$2 million). Next, LPs and GPs share the remaining profit ($20 million) according to
the carry rule: $16 million (= 0.80 [$20 million]) to the LPs and $4 million (= 0.20
[$20 million]) to the GPs.
The second investment generates a loss of $20 million and an IRR of –11 percent.
The loss accrues only to the LPs, and the GPs do not receive a return. At the end of
the second year, partnership should determine the total amount and distribution of
profits to the two groups of the partners. First, with the hurdle rate of 8 percent, the
LPs receive $209.17 million ($100 [1.08] + $100 [1.08]2) including the contributed
capital. Here the assumption is that the preferred return is earned on the invested capi-
tal for the actual investment period. Then, the GPs are supposed to receive 100 per-
cent catch-up, $2.28 million (0.20 [$11.4 million]), in which $11.4 million is equal to
$9.12 million/0.80. However, the total profits only amount to $10 million. Hence, the

GPs receive $0.83 million ($10 – $9.17). With a deal-by-deal carry structure, the GPs
will have already received $6 million from the first investment. Therefore, according
to the clawback provision, the GPs should return $5.17 million (= $6 million – $0.83
million) to the LPs.
Thus, several issues must be considered when implementing the clawback provision:
Should the time value of money that the LPs have forgone be ignored? What is the ap-
propriate way to treat tax payments that the GPs will have already made on their first
carry income? What happens if the GPs (individuals or the general partnership) do not
have enough capital to pay the clawback? All of these contingencies should be written
in LPAs. Mathonet and Meyer (2007) and Schell (2005) offer further discussion on the
complexities and difficulties in enforcing the clawback clause.
Another issue in a deal-by-deal waterfall provision is whether all fees and expenses
or only those fees and expenses associated with exited investments should be recouped
(on a pro rate basis) before profit-sharing. For example, suppose a fund with a com-
mitted capital of $100 million consists of five investments for the first three years of
$10 million each. During this investment period, management fees amount to $6 mil-
lion (= 0.02 [$100 million, 3 years]). If the first investment is sold at $20 million in
the fourth year, without a preferred return, the partnership agreement should specify
whether the amount of profits to be shared is $4 million (profits net of the entire man-
agement fees, i.e., $20 million – $10 million – $6 million) or $8 million (= $20 million –
$10 million – [$6 million/3 investments]). In the latter case, fees are spread out on a
pro-rata basis based on the cost basis of the investments.
In a deal-by-deal waterfall provision, the partnership may introduce the fair value
test, also called the NAV test. The fair value test permits GPs to share profits only after
the estimated NPV of existing investments exceeds a preset threshold. The threshold
typically falls between 110 and 125 percent of the cost basis of un-exited investments.
The fair value test reduces the probability of triggering the clawback provision. How-
ever, GPs can manipulate the estimates and reports of the portfolio companies’ NAVs.
All these issues and complications with profit distributions disappear if a partner-
ship follows a European-style waterfall provision (fund-as-a-whole basis carry). This ap-
proach allows GPs to participate in the carried interest on the whole-portfolio basis at
the end of a fund’s life. Clearly, this method simplifies fund accounting. Fund managers
do not have to worry about over-paying GPs, less need exists to have a clawback provi-
sion, and GPs have less incentive to manipulate the interim valuations of assets. Hence,
this waterfall provision is simpler. A clear disadvantage of this method from the GPs’
perspective is a delay of the receipt of carry for several years. This waterfall is especially
unfavorable for younger GPs who may not have enough monetary resources or income.
The GPs may also have a more difficult time recruiting and retaining talented fund man-
agers with this distribution approach.
A return-all-contributed-capital-first approach lies between the pure American-
style and European-style waterfalls. In a return-all-contributed-capital-first approach,
GPs return the contributed capital to LPs first and then start sharing profits. In the pure
European-style approach, all committed capital is to be returned to the LPs. The interim
investments may generate enough profits to recover contributed capital including fees
and expenses before returning the committed capital to the LPs. Hence, the GPs may
be able to share profits earlier in this case than in the pure European-style approach.

De a l - Le v e l F ees
GPs often receive fees from their portfolio companies, especially in BO funds. These
deal-level fees also called “ancillary fees” or “portfolio company fees” include transac-
tion fees, monitoring fees, and break-up fees. These fees represent compensation to the
GPs for the broad range of services they provide to portfolio companies. When acquir-
ing target firms, GPs perform due diligence, negotiate the terms of the acquisitions, and
arrange financing. That is, they provide investment banking services. They also serve as
the board of directors and continue to provide advisory services to portfolio companies
and receive monitoring fees. GPs sometimes receive break-up fees when an acquisition
fails due to the target company (e.g., when the target company accepts a higher offer
from a third party). Hence, a break-up fee is intended to remunerate GPs for their time
and resources spent in preparing the acquisition.
If GPs do not receive deal-level fees, the value of the portfolio companies will in-
crease by the amount of the fees and LPs’ profit would increase by the corresponding
amount. In the case of break-up fees, portfolio companies do not directly pay break-up
fees. However, LPs have to bear the opportunity costs of forgoing other investment op-
portunities. Therefore, deal-level fees are another layer of compensation that GPs re-
ceive from LPs.
Several problems are present with the practice of paying deal-level fees. First, LPs
already pay management fees to compensate GPs for their efforts in engaging in vari-
ous activities to improve portfolio values and enhance fund performance. Hence, the
deal-level fees are redundant. Second, the deal-level fees increase the fixed part of
GPs’ compensation and weaken aligning interest between LPs and GPs because if
GPs receive deal-level fees, such fees will reduce the likelihood of participating in
carried interest. Third, of all fee terms, deal-level fees are the most opaque. LPAs typi-
cally do not have explicit contractual terms stipulating when, how much, and what
kinds of deal-fees will be charged. This practice has come under close investigation
by the Securities and Exchange Commission (SEC) (Securities and Exchange Com-
mission 2014).
Without adequate monitoring by LPs, an incentive could exist for GPs to improp-
erly maximize deal-level fees. For instance, GPs may collect deal-level fees (especially
transaction fees and monitoring fees) by employing services companies (directly or in-
directly) affiliated with the GPs, thereby compensating themselves secretively.
Deal-level fees should accrue to the fund, be shared with LPs, or be used to offset
management fees (called management fee waiver or offset). Management fee waiver also
helps GPs reduce their tax liabilities by converting ordinary income (management fees)
to capital gains (carried interest). This has been one of the most debated practices in PE
funds (Polsky 2008).
Literature Survey
This section reviews both academic research and industry surveys to explore both
cross-sectional and time-series variations in PE compensation structure. This section
presents findings from previous studies about the following questions: What are the

distributional characteristics of compensation structure? Do systematic differences

exist between VC and BO partnerships in their fee structure? Are fees related to other
fund characteristics such as size and age, and if so, why? Are fees designed to gener-
ate enough incentives to GPs? What is the relationship between fee structure and fund
performance? Does any evidence support distorted incentives of GPs? Does the relative
bargaining power of LPs and GPs affect fee structure?
The literature on compensation structure of PE funds is relatively small largely due
to the private nature of the industry. Most studies obtain information on fund terms
from proprietary and confidential sources such as large investors in PE funds. Other
than these proprietary sources, perhaps the most comprehensive publicly available
source for fund terms and conditions is Preqin’s Private Equity Fund Terms Advisor.
However, Preqin’s data do not disclose fund identities and other detailed fund infor-
mation such as exact fund size and performance, thereby increasing the difficulty of
studying the relationship between fund terms and other fund characteristics including
performance.
C ompens at ion S t r uc t u r e I n P r a c t ice

To date, Metrick and Yasuda (2010) and Robinson and Sensoy (2013) provide the
most extensive studies of PE compensation structure. Both studies are based on fee in-
formation collected from undisclosed but large LPs. Table 20.1 summarizes the distri-
butional characteristics of fee terms from the two studies.
Management fees are about 2 to 2.5 percent of committed capital. Both studies show
that VC funds tend to charge greater management fees than BO funds, with a median
value of 2.5 percent and 2 percent, respectively. This finding is consistent with earlier
studies (Sahlman 1990; Gompers and Lerner 1999).
The fee level or basis typically changes over a fund’s lifetime. According to Metrick
and Yasuda (2010), 80 percent (for VC) to 90 percent (for BO) of the funds change
their fee level or basis. In Robinson and Sensoy (2013), the rate is about 60 percent for
both VC and BO funds. One interesting asymmetry between VC and BO managers is
that VC managers tend to change their fee level more often than their fee basis and BO
managers vice versa. Given that the better part of PE funds choose to change either fee
level or basis, the rationale behind this choice would be an interesting area for further
investigation.
Carried interest is almost always 20 percent. Metrick and Yasuda (2010) find that
95 percent of VC managers and 100 percent of BO managers choose a 20 percent carry.
According to Robinson and Sensoy (2013), more than 90 percent of the funds choose
20 percent. The cross-sectional variation of carried interest is much smaller than that of
management fees. The highly concentrated carry level may reflect a lack of transparency
on GPs’ ability in the industry. If this is true, as the industry matures, greater variation
in carried interest across different PE partnerships may be observed. Most funds have a
hurdle rate of 8 percent. While most BO funds stipulate a hurdle rate in their partner-
ship agreement, less than half of VC funds contain this term.
Studies on deal-level fees such as transaction fees, monitoring fees, and termina-
tion fees are rare. Fürth, Rauch, and Umber (2013) examine the deal-level fees of 93
portfolio companies that went public from 1999 to 2008. They collect detailed data on

Table 20.1 Summary Statistics of Fee Terms

Metrick and Yasuda Robison and Sensoy
Sample Period 1989–2012 1984–2010
VC BO VC BO
Number of funds 94 144 295 542
Fund size 322 1,238 207.96 987.98
[225] [600] [106.12] [312.91]
Management fee % % % %
2.24 1.78
[2.50] [2.00]
<2% 9.6 64.9 5.0† 23.0†
2% 46.8 51.8 26.0 43.0
>2% 42.6 9.6 46.0‡ 7.0‡
Fee % change 55.3 45.1 53.0 40.0
Fee basis change 42.6 84.0 14.0 43.0
Change % and basis 16.0 38.9 6.0 24.0
Carried interest
Percentage % % 20.44 19.96
[20.00] [20.00%]
<20% 1.1 0.0 1.0 2.0
20% 94.7 100.0 89.0 97.0
>20% 4.3 0.0 10.0 1.0
% hurdle rate 44.7 92.4
Note: This table compares descriptive statistics of fee terms from Metrick and Yasuda (2010) and
Robinson and Sensoy (2013). The numbers in brackets are medians.
† Management fee is exactly equal to 1.5 percent.
‡ Management fee is exactly equal to 2.5 percent.
Source: Table 2 in Metrick and Yasuda (2010) and Table 2 in Robinson and Sensoy (2013).
deal-related fees from the initial public offering (IPO) prospectuses of these reverse lev-
eraged buyouts (RLBOs). The study documents the following: (1) 57 percent of the
portfolio companies pay deal-level fees; (2) the proportions of deals paying monitor-
ing, transaction, and termination fees are 54.8 percent, 38.7 percent, and 24.7 percent,
respectively; (3) total deal-level fees amount to, on average, 2.32 percent of enterprise
value (in dollar terms, $10.79 million in which the average deal size is $923.3 million);
and (4) about 60 percent of the funds have transaction fee rebate rules. The fee rebate
rules specify whether transaction fees should accrue to the fund and how LPs and GPs
should share the fees.

Dechert and Preqin (2011) survey 143 BOs and document that transaction fees
amount to an average of 1.09 percent of deal size from 2005 to 2010 and monitoring
fees (for 95 BO deals) are on average 1.78 percent of earnings before interest, taxes,
depreciation, and amortization (EBITDA). Fee rebate rules exist for about 81 percent
of the deals. These statistics are largely consistent with anecdotal evidence showing
transaction fees are typically 1 to 2 percent of enterprise value, and monitoring fees
are 1 to 5 percent of EBITDA of a portfolio company (Metrick and Yasuda 2011; Stoff
and Braun 2014).
This section explores fee structure in PE funds. Notably, it identifies several differ-
ences in fee structures between VC and BO funds. Management fees are higher and
the change in fee levels is more frequent in VC funds. Hurdle rates and deal-level fees
occur more often in BO funds. Although this asymmetry may reflect different invest-
ment technology and operation/production processes of the two types of funds, a more
thorough theoretical consideration would provide further understanding about the
economics of PE funds.
The De t e r min a n t s O f F ee S t r uc t u r e
Several studies document the relationship between fee structure and fund or market
characteristics with little inconsistency. This section summarizes the relationships doc-
umented in Gompers and Lerner (1999), Robinson and Sensoy (2013), and Stoff and
Braun (2014). Several industry surveys also confirm the findings in these studies (SCM
2009; Dechert and Preqin 2011).
In general, fund size (committed capital) and age (fund sequence number) have a
negative relationship with management fees (as a percentage of fund size) for both VC
and BO funds. Additionally, capital flows into the PE industry are positively associated
with management fees. However, carried interest is not significantly related to capital
flows to the industry, but it is positively associated with fund size and fund age especially
for VC funds.
Several patterns emerge. First, management fees seem more cyclical than carried
interest implying that GPs negotiate for higher fixed pay when they have greater bar-
gaining power (i.e., when larger capital inflow occurs) (Robinson and Sensoy 2013).
Second, younger and smaller funds have higher management fees and less carried in-
terest (i.e., smaller pay-for-performance). Gompers and Lerner (1999) interpret this
result as consistent with a learning model in which initially neither LPs nor GPs know
the GPs’ ability, and GPs have a greater incentive to make an effort to establish a reputa-
tion. Over time, however, as a GP’s reputation builds, extra incentive via greater pay-for-
performance is required to induce greater efforts from that GP. Hence, compensation
packages include larger variable components (i.e., carried interest) as a fund becomes
larger and older. The positive relationship between experience and pay-for-performance
also appears stronger for VC funds than BO funds. This asymmetry may imply greater
information opaqueness on venture capitalists’ ability in early stage funds and greater
informativeness of experience of venture capital funds.
In a unique study of PE funds in a cross-country setting involving 50 funds from
17 countries, Cumming and Johan (2009) show that a country’s legal condition affects
compensation structure. They find that management fees are larger in countries with

weaker legal environments, whereas carried interest is smaller in those countries. Their
interpretation is as follows: When a country with a poor legal condition has an opaque
information environment, evaluating the GPs’ skill becomes more difficult. Basing the
GPs’ pay on noisy signal about their efforts or skills is not optimal. Therefore, GPs prefer
that a greater fraction of their pay comes from fixed components.
One important missing variable in examining the relationship between fee structure
and other fund characteristics in the previous studies is GPs’ (ex ante) ability. Thus,
their analyses are subject to an omitted variable bias. In an attempt to address this issue,
Cumming and Johan (2009) examine how GPs’ personal characteristics relate to fee
structure. They find weak evidence that GPs with PhD degrees in science have higher
carried interest.
Overall, the information environment in the PE industry appears to be poor. Assess-
ing managers’ ability is challenging given the secretive nature of their investments (with
regards to due diligence, selection, and monitoring processes), long-term investment
horizon (in which performance is materialized long after inception and informative sig-
nals about managers cannot be observed frequently enough), and a lack of secondary
markets (from which fund managers’ skill is recurrently evaluated). Thus, compensa-
tion contracts have evolved to incorporate these imperfections of PE markets.
S i z e O f G p I ncen t i v es
An important issue in compensation contracts is whether the compensation structure
gives strong incentives for agents to make efforts for the benefit of principals (the
LPs). In the context of PE funds, fee structure should align the interests of GPs with
LPs. In particular, the LPs would want to have a greater fraction of variable compo-
nents (e.g., carried interest) relative to fixed components (e.g., management fees) in
the GPs’ total pay.
Metrick and Yasuda (2010) estimate the expected revenue of GPs coming from fixed
components (e.g., management fees and transaction fees) and variable components
(e.g., carried interest and monitoring fees). Under several reasonable assumptions about
investment speed, volatility, and exit timing, they show that the expected fee revenue
from fixed components is twice as large as that from variable components. This result is
discomforting and is largely consistent with the view that pay-for-performance may not
be large enough in PE funds.
Yet, explicit incentives generated from fund terms and conditions are only a part
of the total incentives that GPs face. When GPs manage a fund, they are concerned
with raising a follow-on fund. Current and past performance affects the success and
size of the next fundraising. The expected GPs’ revenue coming from fixed compo-
nents of the total fees from future funds will become greater if GPs can raise more
funds. Therefore, this indirect and implicit pay-for-performance also incentivizes
GPs, although it is missing in the previous analyses. Addressing this gap, Chung,
Sensoy, Stern, and Weisbach (2012) estimate the magnitude of the indirect pay-
for-performance and document that the indirect incentives are as significant as the
direct incentives from carried interest. Taking the results of the two studies, the ex-
pected revenue from variable components appear as large as that from fixed compo-
nents of total fees.

The Re l at ionship B e t ween F ees An d F un d P e r fo r m a nce

LPs want to structure fees in ways that incentivize GPs to improve fund performance.
Does a positive relationship exist between fee structure and fund performance? Gompers
and Lerner (1999) examine the relationship between carried interest and fund perfor-
mance as measured by the size of IPO relative to committed capital, but they do not find
a positive association between the two variables. Similarly, Robinson and Sensoy (2013)
estimate the relationship between various fee components and net-of-fee fund returns and
do not find that high ex ante pay-for-performance generates high ex post returns.
These findings do not necessarily imply that a performance-based fee is not an im-
portant element to incentivize GPs to work harder so that their funds produce higher
returns. First, the relationship between compensation structure and fund returns is
endogenous. Especially, as pointed out in the previous section, the previous empiri-
cal studies exclude many variables. For example, the GPs’ ability is hard to measure
and challenging to control in empirical investigations. Also, other incentive-alignment
mechanisms such as covenants and preferred returns are not considered. Such missing
factors could obscure the effect of the expected pay-for-performance on performance.
Second, as the authors of the two studies argue, compensation structures may be in
equilibrium. Gompers and Lerner (1999) contend that the learning model does not nec-
essarily imply a positive association between carried interest and performance because
compensation is properly structured to incentivize agents based on market information
on their ability. For example, younger GPs do not require strong performance-based
pay because they have a strong reputational incentive to work diligently. As Robinson
and Sensoy (2013) maintain, higher pay-for-performance may generate higher returns
gross-of-fees but GPs simply collect all economic rents that their efforts have produced.
F ees An d I ncen t i v e Dis to r t ion

Although the GP–LP relationship is fraught with potential agency problems, not much
systematic empirical evidence exists on whether fee structure directly affects GP behav-
ior at the expense of LPs. Robinson and Sensoy (2013), who conducts the only study
exploring this issue, find that GPs delay exits when fees are based on invested capital,
while they expedite exits when they are owed profit distribution around waterfall dates.
Ample evidence exists that shows other types of conflicts of interest between LPs and
GPs. For example, as Gompers (1996) shows, younger VC partners take their portfolio
companies public earlier and at a higher cost than older counterparts (i.e., greater under-
pricing) to establish a reputation and facilitate new fundraising. Cumming and Walz (2010)
document that PE funds have an incentive to overstate the value of their existing investments
to help their follow-on fundraising especially in countries with weaker legal conditions and
less strict accounting rules. Barber and Yasuda (2013) and Brown et al. (2014) also find that
PE managers manipulate reported NAV before a follow-on fundraising occurs.
Time S e r ies D y n a mics An d The F u t u r e O f F ee S t r uc t u r e

Since the financial crisis of 2007–2008, much debate has occurred about compensa-
tion practices in the PE industry. As market liquidity compromised these markets,

LPs have gained an advantage when negotiating contractual terms with GPs. In par-
ticular, the fees and expenses that PE funds charge have come under closer scrutiny
(Katz 2014; Maremont 2014). A trend has emerged toward lower management fees
and carried interest and more transparent disclosure requirements for deal-related
fees (Hudec 2010; Leamon, Lerner, and Garcia-Robles 2012; Mahieux 2013). The In-
stitutional Limited Partners Association (ILPA) also published a guideline for LPAs
to promote the interest of limited partners (Institutional Limited Partnership Asso-
ciation 2011).
Whether this movement will dramatically alter PE compensation practices is un-
certain. The PE industry is characterized by its boom and bust cycle (Kaplan and
Strömberg 2009). Since its inception, the industry has experienced three distinctive
crashes: one in the early 1990s (the collapse of the high yield bond market), another
in the early 2000s (the burst of the dot-com bubble), and the third in the late 2000s
(the financial crisis of 2007–2008). Each failure put downward pressure on fees earned
by GPs (Fenn, Liang, and Prowse 1995), followed by a recovery of fees to pre-crash
levels, except the most recent one. In other words, fees also appear to be cyclical. Rob-
inson and Sensoy (2013) document that LPs pay smaller percentage management fees
during bust periods.
If history is any guide, as the economy rises and fundraising activities pick up (Preqin
2012; Bain & Company 2014), fees will revert to their pre-2008 level. However, other
controversial fund terms (e.g., deal-level fees and management fee waivers) may be ad-
justed to be more favorable to the LPs. For example, Stoff and Braun (2014) show that
although fund terms have remained remarkably stable since 2007, progress has occurred
toward more LP-favorable terms, especially, in waterfall provisions and deal-level fees.
Summary and Conclusions

A distinctive feature of the PE industry is its secrecy. Investors concede this private
nature of the business so that fund managers can creatively capitalize in a timely
way on investment opportunities with minimal constraints. However, the secrecy
and flexibility granted to the fund managers come at a cost to investors in the form
of costly contracting and slow learning of GPs’ ability. Partnership agreements
should be carefully written to protect the interest of the investors by considering
various circumstances in which conflicts of interest between LPs and GPs may
arise. Besides, informative signals containing fund managers’ abilities are scant,
which impedes the investors’ learning process. Perhaps this lack of information is
why contractual terms are remarkably homogeneous across funds and the industry
is so cyclical.
This chapter reviews the basic structure and variants of different types of fees that
GPs earn. Current and potential investors in PE funds should meticulously examine fee
terms, understand the intricacies of fee structures, and demand transparency in distri-
bution methods when needed. As the industry matures, a secular movement may occur
in this direction. As more information about the workings of PE funds becomes ac-
cessible and the learning process improves, a greater heterogeneity of fund terms and
conditions adequately reflecting GPs’ characteristics may emerge.

Discussion Questions
1. Consider a fund with a 20 percent carried interest and a hurdle rate of 8 percent. The
committed capital is $100 million, and the entire amount is invested on the first day
of its operation. The investment is sold for $110 million in one year, and the fund is
liquidated on that day. Describe how profits are split between LPs and GPs under a
100 percent catch-up provision and a 50 percent catch-up provision.
2. Consider two funds that each invest $100 million today and produce $120 million
over the next three years. Both have an 8 percent hurdle rate, a 100 percent catch-up
premium, and a clawback provision. The two funds generate cash flows at different
times as shown below. Compute how the LPs and GPs will share the profits.
0 1 2 3
Fund A −100 +108 +2 +10

Fund B −100 +100 +10 +10
3. Denote c as the carried interest, h as the hurdle rate, and u as the catch-up. Deter-
mine the IRR of a fund at which the catch-up provision expires (i.e., GPs and LPs
share profits according to the preset carry rule).
4. Discuss how the relative bargaining power of LPs and GPs affects various fee terms
in LPAs.
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OUP-FIRST UNCORRECTED PROOF, March 6, 2015

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C om pe n s at ion S t ru ct u re 361

Compensation Structure of PE Funds

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C om pe n s at ion S t ru ct u re 363

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0.50($x) = 0.20($8 million + $x) (20.1)

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C om pe n s at ion S t ru ct u re 365

Case 1. 100% Catch-up Provision

Figure 20.1 Illustration of Profit-Sharing between Limited Partners and

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deal-by-deal or front-end-loaded distribution, and (2) European style, which is also

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C om pe n s at ion S t ru ct u re 367

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C om pe n s at ion S t ru ct u re 369

distributional characteristics of compensation structure? Do systematic differences

C ompens at ion S t r uc t u r e I n P r a c t ice

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Table 20.1 Summary Statistics of Fee Terms

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C om pe n s at ion S t ru ct u re 371

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C om pe n s at ion S t ru ct u re 373

The Re l at ionship B e t ween F ees An d F un d P e r fo r m a nce

F ees An d I ncen t i v e Dis to r t ion

Time S e r ies D y n a mics An d The F u t u r e O f F ee S t r uc t u r e

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Summary and Conclusions

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C om pe n s at ion S t ru ct u re 375

Fund A −100 +108 +2 +10

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