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April 03, 2014

Why LPs don't care about lowering the 2-and-20 Private Equity Fund Fee Structure

Private Equity International (PEI) has used Bain Capital's new fund raising to provide an interesting take on why the decades old Private Equity fund fee structure of "2 and 20" (2% of the fund size as annual fees and 20% "carry" or profit share) has barely come down despite the financial crisis and why LPs ultimately don't care enough about them.  Extract from the article titled "Bain and the great fee debate":
For years, Bain has been one of the few outliers to the prevailing 2-and-20 model, charging 2-and-30 instead  - and with some success, given that it raised five funds this way. This time round, however, it decided to offer LPs three options: a 1.5 percent management fee with 20 percent carry and a 7 percent preferred return, a 1 percent management fee with 30 percent carry and a 7 percent preferred return, or a 0.5 percent management fee with 30 percent carry and no preferred return.

Since LPs have long complained that management fees are too high, especially for the bigger funds (it was the most commonly cited sticking point in negotiations in our Perspectives investor survey last year), you’d expect them to go for the second or third option. But our LP source suggested that in practice, most investors would go for option one – because it’s “closest to market terms”. If he’s right, the net outcome may well be that one of the industry's only outliers ends up looking a lot more like everybody else.

...Indeed, however much investors grumble about fees, it doesn’t seem to affect their investment decisions all that much. And as long as LPs are not voting with their feet, GPs have little incentive to do anything about it. As Ed Hall, a partner at King & Wood Mallesons SJ Berwin, told us recently: “Investors don't generally select a fund because it has lower-than-market fees, so GPs don't generally have anything to gain by lowering [them].” At the moment, good funds can get away with charging pretty much what they want, while investors are unlikely to back weak funds just because they get a good deal on fees. So it’s hard to see the status quo changing any time soon.

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