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July 22, 2009

Time to rethink GP compensation?

"Super LP" Chris Douvos has proposed a new fee formula for Private Equity funds.
Currently, LPs worry that the carry system grants GPs a free option in times of frothy markets; LPs ask: why pay an incentive to people who simply capture beta? GPs on the other hand bellyache about how long-dated carry payouts can be; after all, those wacky hedgies get paid every year (watch those high watermarks, boys). But what if we rethought the way in which carry is paid? What if we instead paid people on a deal by deal basis, but only when they beat the opportunity cost of an appropriate public index? And let's acknowledge that the public markets are a fast rabbit, so we should pay people a substantial portion (25%? 50%?) of the excess return above equity-substitute cost of capital. You would have true-ups every couple of years to ensure that groups didn't get paid more than X% of the net profits on the fund.

Something like that could be a win-win: LPs get a formalization of private equity's return enhancing essence while GPs pull carry forward (increasing the PV!) and could even get paid on flat (or down!) investments, as long as they exceeded public market comps.

While we're at it, we could also get everyone on a budgeted fee (now I'm getting Pollyanna -- sorry: I've exceeded my daily Diet Coke allotment). Pay yourselves well, folks; this is America and there's a market for your services, but let's not be bonusing back millions of dollars in excess fees . . . let's focus on cap gains, not W-2 income.

Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of data and analysis on private equity, venture capital and M&A deals in India. View free samples of Venture Intelligence newsletters and reports. Email the author at arun@ventureintelligence.in