Note on Compensation of General Partners in the

Venture Capital and Private Equity Industry

By Manu Midha

Abstract: The article defines various components of the total compensation of General Partners
in a VC / PE setup (which could be a partnership or a private limited concern). It talks about
some of the recent trends in the industry and what determines the exact compensation
structure.

The article may reflect some of the biases held by the author, and one is free to agree/disagree.
Comments and suggestions are welcome. No character/fact in this note is fictitious.

Definitions

GP - General Partners of a PE/VC fund are the managers of the investing entity. They are the
ones who raise capital, identify and evaluate investment opportunities, make investments and
finally exit them and return the capital back to the investors. Most of them also co-invest with
the LP’s in the fund, but normally their investments are limited to around 5% of the total size of
the fund.

LP - Limited partner of the PE/VC fund, the investors to the PE fund. These are called ‘Limited’,
as their roles are limited to making investment to the fund and not in the general management
of the fund. They typically meet at periodic intervals to monitor and discuss investments made
by the fund.

Illustration: For the purpose of this note, we will assume a WIMWI PE fund, of 10 year life and
size $1Billion, managed by a team of GPs headed by ‘Maacho’ ji, and invested into by a team of
LP’s represented by ‘Nacho’ ji (doesn’t he look like one?, believe me he has a big portfolio!!).
 General Partners Limited Partner Limited Partner Limited Partner
[The PE Firm] (Eg. Pension Fund) (Eg. Univ. Endow.) (Eg. Fund of funds)
(Partnership/Pvt. Ltd. Co)

Invest ($$) Invest ($$)

Manage and
Co-Invest ($$)
PE/ VC Fund (The WIMWI PE Fund)

Receive Investments
($$) ($$) ($$) ($$)

Portfolio Portfolio Portfolio Portfolio

Company Company Company Company
1

In our Current Illustration:

GPs represented by ‘Maacho’ji LPs represented by ‘Nacho’ji

Figure 1: Structure of a typical PE / VC Fund

Introduction

Executive compensation has been a topic for much debate off late. There have been several
reports published on compensation of executives working with banks and other financial
institutions. Not much has really been said about compensation of General partners in Private
equity (and Venture Capital) firms. This is not really because they are less paid than the former
or because most of this industry (PE/VC) moves with a lag to the actual financial markets, but
because there were fewer funds being raised and new compensation plans being published off
late.
Demystifying Compensation of GP’s

There are three basic ways in which General Partners are compensated. These are:

1. The fund management fee: Also called Management fee, this is an annual fee and is
normally a fixed percentage of the total capital committed during the investment period and
sometimes a fixed percentage of unrecovered capital thereafter.

Committed capital is the amount of money that the LP’s have paid cumulatively upto that
point. The industry standard is about 2% for Venture funds (smaller) and about 1% for larger PE
funds.

Unrecovered capital is the part of the fund that is not paid by the LP’s as yet. Not all money is
paid upfront by LP’s but is paid in installments.

Illustration 1:

Say for our WIMWI Fund the LP’s, led by ‘Nacho’ji, have committed to pay $ 1 Billion over 5
equal installments in 5 years (4 – 5 installments is the norm) i.e. $ 200 million per installment.
Let us also assume a 2% fund management fee to be paid to ‘Maacho’ji and group.

Therefore, for the first year the Fund management fee amounts to $4 million (2% of $200
million) for the second year it would be $ 8 million and $ 12 million for the third year and so on
till it reaches $ 20 million in year 5. (Remember fund management fee is a percentage of the
cumulative capital paid by LP’s).

Now after year 5, it stays constant at $ 20 million per year for the last 5 years.

This fee is normally used to cover the fixed expenses of the fund, eg. salaries, office rent, etc.

Exceptions from the illustration:

This may be calculated annually / semi-annually or quarterly based on the pay-in structure of
the fund.
This fee is often reduced after the fund’s investment period (normally the first 5 years) equally
over the last five years.

2. Carry: Carry or carried interest as it is called, is the share of the capital gains that a private
equity partnership (or company) earns from its investments. Upon successful exit or upon
maturity of the fund, the estimated profit on the investment is calculated and is distributed in a
pre-determined ratio.

Industry standard for this share is 20%, i.e. after paying off the LP’s their committed capital
(principal) the gains are divided in the ratio of 80 – 20 and are distributed to the LP’s and GP’s
respectively.

Illustration 2: Say in our own $ 1 Billion WIMWI fund, upon all successful exists after the 10th
year the fund fetches an exit value of $ 2 Billion.

This means capital gains of $ 1 Billion over the base investments. Assuming the industry
standard payout for Carry (80/20), ‘Maacho’ji and group would receive $ 200 million as the
Carry, from the fund. While ‘Nacho’ji would receive $800 million as profit on his $ 1 Billion
investment.

This was the most basic way though and there are a number of ways in which this carried
interest is distributed, with respect to timing and magnitude.

The concept of Preferred return

There is a concept of preferred return, or commonly called as the huddle rate, wherein over
and above what the LP’s have initially invested (their Principal) they expect a basic return
(huddle rate) to be paid to them upon maturity of the fund, before the profits are divided
between them and the GP’s as per the pre-specified ratio.

Illustration 3: Say if for example in WIMWI fund, the LP’s (‘Nacho’ji) had demanded a preferred
return of 10% over the life of the fund.
In this case based on the pay-in structure of the fund ($ 200 million over 5 years) the breakeven
for the fund after 10 years is not $ 1 Billion but $ 2.16 Billion. Therefore even though ‘Maacho’ji
and group earned $ 2 Billion at exit they are not entitled to any carry based on these terms.
Only when the exit value would have been above this threshold, carried interest would be
distributed as 80% to Nachoji and 20% to Maachoji.

3. Professional service fee: GP’s are known to provide a host of services to their portfolio
companies. Services may include investment banking services, monitoring of the company,
consulting in niche areas, debt raising, etc.

For all these services, the GP’s normally charge their portfolio companies service fee which is
also sometimes called Transaction fees.

There has been a lot of debate on the topic of whether GP’s like ‘Maacho’ji and group should be
taking fee from their own portfolio companies (it’s like charging your wife for help at home).

To make the incentives aligned, many a time the Fund contract makes it mandatory to set off
50% of the professional fee gained from these services against the Management fee of the
Fund managers. This means that only 50% of the fee is given out to the GP’s while the rest is
treated as an income of the fund, and would accrue to the investors (LP’s).

My Two Cents:

The issue of percentage of carry vs. management fee is a subject of huge debate. For a fund,
both these are marketing variables to play with when they are trying to raise a new fund. Big
and respected GPs like ‘Maacho’ji, or the Blackstones and KKRs of the world who have relatively
stable sources of funding, do not compromise on either of them. While smaller funds in difficult
times like these, might lower the management fee or carry or both to attract investors.

Having said that, for investors or LP’s the issue of fee is secondary and comes in to make close
choices between very funds with similar past performances, etc.

Further increasing carry at the expense of management fee sometimes shows confidence of
GPs on their investment philosophy and may attract investors.
Variations are also expected in the percentage of management fee across the size of funds, and
larger funds would have a lower management fee than smaller funds, as they reflect fixed cost
of operations of the General partnership. Therefore even though a fund may be large in value,
but it may not be proportionately larger in the management team size, etc.

Recent trends in the industry show that few VC firms have lowered their management fee as
investor funds are hard to come by.

References:

Few relevant pdf’s/links/articles which could be looked up for further information on this topic:

1.http://www.pehub.com/wordpress/wp-content/uploads//watson-wyatt_private-equity-fees-
and-terms.pdf

2. http://deals.venturebeat.com/2009/08/31/is-it-time-for-the-venture-capital-two-and-twenty-to-end/

3. http://mstblog.ohsu.edu/?p=747

For comments and suggestions, the author can be reached at manu.midha@gmail.com.