The Math of Private Equity: 2/20, 3-on-5, and 1-in-8

Abstract

Given the standard 10-year cycle of private equity (PE) funds, 2 percent year-on-year management fee on committed funds, and 20 percent carry fee charged by funds’ managers or general partners (GPs), a 3 times cash-on-cash return at disinvestment in 5 years is required to achieve median 15 percent return (IRR) for funds’ shareholders or limited partners (LPs). The implied 25 percent discount rate at which portfolio companies’ cash flows are valued is justified as exposure to non-diversifiable risk of failure. E.g., a 9 percent discount rate of a comparable company with a probability of failure of 1 in 8 yields a compound rate of 25 percent. Implications in turmoil times: (1) the 2/20 fee structure subject to cut down and evolution to dynamic schemes (e.g., on deployed funds); (2) EBITDA growth as the main source of PE return due to steady multiples and avoidance of over-leverage; (3) reduction of returns’ volatility by screening markets and sectors, and avoidance of carry trade risk. Conjectures: (a) sovereign funds weight increase as LPs, (b) market and sector specialization across funds, and (c) PE pitch switch from financial to managerial value added.

Keywords: Investment Decisions, Venture Capital, Private Equity, Investment Banking

JEL Classification: G11, G23, G24