Understanding Private Equity Returns and Fees
The fees associated with Private Equity create a significant impediment to consistent, outsized returns to the investor. Let’s examine how the math works for a typical Private Equity Investment. The terms are 2% management fee, 20% of the profits, and a 6% hurdle rate.
If the PE firm generates a 15% pre-fee annual return, the investor will receive the following:
15% Pre Tax Return
-2% Management Fee
-1.8% Performance Fee (20% of the amount above the 6% hurdle rate)
11.2% Net To Investor
3.8% Net To Private Equity Firm
The 3.8% net return to the PE firm is a bit over 25% of the topline pretax return.
Some investors fail to grasp that the private equity firm is entitled to a whopping 25% of the total profits, not just the profits beyond the hurdle rate. That’s why there are so many PE Manager Billionaires. 25% of ALL the profits without having to put up a dime of their own money. Some PE firms do invest their own funds in deals but that doesn’t change the math for the investor. A number of PE firms have layered additional fees into deals on top of the 2 and 20 that are advertised. You can google this for details if you’re still interested in Private Equity.
PE firms generate excess returns by using leverage. A firm might buy a business for $100M, pay $50M in cash, and borrow $50M. You could replicate this structure by investing in the S&P 500 on margin.
Over the long run, the S&P 500 has had an average return of 8%. Until recently (prior to the Fed tightening), you could borrow funds against your stock portfolio at 2% from Interactive Brokers (IB). Let’s look at the returns from that strategy using the historical 8% S&P 500 return.
Use $100K of your own funds and borrow $100K from IB. Purchase $200K of an S&P Index fund.
$16K 8% Annual return from a $200K investment
-$2K 2% Interest Charged by IB on the $100K you borrowed
$14K Annual Profit after interest expense
14% Annual Return ($14K Profit on $100K Cash invested)
Many firms have a maintenance margin of 25%. That means if you buy a stock or index that’s priced at $100, you have to put up $50 as initial margin. You do not need to add additional funds to that position unless the stock falls below $67.
In our opinion, the main advantage that PE firms have over individual investors is they can borrow without needing to be concerned about getting a margin call. An individual investor can use a lower level of margin and significantly reduce the possibility of a margin call. You can select your level of risk/return. You can read our article on “Using Margin to Enhance your Returns” to see some examples. We do not suggest using margin to enhance returns just as we do not suggest investing in PE.
If you’re already rich, meaning you have all the money you need to live life the way you want to, why increase your risk of ruin to be double rich? I have one of Buffett's quotes on my wall. “I've never believed in risking what my family and friends have and need in order to pursue what they don't have and don't need.”
I look at this quote several times a week. It’s helped me dial back my risk many times.
Private Equity employs some very smart people. Unfortunately, for the investor, much of the excess returns generated by those smart people, stays with those smart people. Private Equity garners a fee of 2% of your investment per year regardless of their performance.
Here’s a link to a NYT article that discusses private equity returns vs the S&P 500. Draw your own conclusions.
https://www.nytimes.com/2021/12/04/business/is-private-equity-overrated.html
