Secrets of Private Equity

Private equity firms manage some $1 trillion of global capital, yet because they are highly secretive, much remains unknown about their internal economics. How do PE firms organize themselves, for example, and how do they capitalize on their success?

Some answers emerge from a paper by Wharton finance professor Ayako Yasuda and Yale School of Management finance professor Andrew Metrick titled, "The Economics of Private Equity Funds." The paper was presented at a recent Wharton conference, sponsored by the Weiss Center for International Financial Research, whose theme was "A Global Perspective on Alternative Investments." The authors gained access to an unusually fertile data set, the private equity portfolio of one of the world's largest limited partner investors. On condition of anonymity, the investor furnished data on 238 different PE funds in which it had invested between 1992 and 2006. Of those 238 investments, 144 were buyout funds and the other 94 venture capital funds.

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Stable Fee Revenues

The study's most important conclusions, according to Yasuda: First, some 60% of PE firm revenues come from fixed-revenue components that are unaffected by performance; and second, while venture capital firms tend to earn more than buyout firms per dollar under management, buyout funds are substantially more scalable and, therefore, can earn much more per partner and per employee. In addition, managers of successful funds can command better terms for themselves as they launch new, larger funds.

Most private equity funds take the form of limited partnerships, with a PE firm serving as general partner; the limited partners -- large institutions and wealthy individuals -- put up the bulk of the capital. Each limited partnership typically lasts for 10 years, with terms of the general partner's compensation spelled out at the fund's inception. The general partner's compensation contains a fixed component -- an annual management fee of 2% or more -- plus a variable component that includes carried interests in partnership holdings. Successful buyout firms often lay claim to some of the transactions fees that their funds generate. In addition, the most powerful limited partners -- large state pension funds, for instance -- may also command a share of the carried interest.