Private equity and venture capital funds are becoming an increasingly popular investment option for everyday investors looking to diversify their portfolios and achieve higher returns. However, investing in PE and VC funds comes with its own set of fees unique to the industry. These fees are full of jargon and can be confusing. In this article, we will explore how PE & VC fees work and what you should be aware of before investing in a fund.
Generally speaking, there are three types of fees associated with PE & VC funds:
- Management Fees: The management fee is a percentage of the committed capital that investors pay to the fund manager to cover the costs of managing the fund. This fee typically ranges from 1% to 3% of the committed capital, with the most common being 2%, and is paid annually.
- Performance Fees: The performance fee, also known as the carried interest or carry, is the fee paid to the fund managers as a percentage of the profits generated by the fund. This fee is usually around 20% of the profits. Sometimes, this fee is only paid after the fund has exceeded a predetermined rate of return, known as the hurdle rate, typically around 8%. These fees are very important because they align the interests of the fund manager and the limited partners (investors in the fund).
- Other: In addition to the management and performance fees, there may be other one-off fees, such as transaction fees, closing fees, monitoring fees, and legal fees. These fees vary depending on the fund and should be carefully considered before investing. Typically, however, these fees are small in comparison to the management fees and performance fees.
While the fees associated with PE and VC funds are high compared to investing in the public stock market, investors have been willing to pay them because overall these funds have outperformed public markets. Not to mention the added diversification that exposure to private markets gives investors. At the end of the day, what really matters to investors is not fees, but the net returns the fund generates after fees.
Fees do impact the overall returns generated by the fund, however. For example, a fund could generate a gross return of 20% but the investors may actually receive a net return of 16% because the management and performance fees would constitute the other 4%.
Another factor to consider is the timing of the fees. Management fees are usually paid annually, regardless of whether the fund is generating any returns. This means that investors continue to pay management fees even in the early years when all capital may not be invested. This is what results in the J-Curve, which we wrote about in a previous edition of PE 101. On the other hand, performance fees are only paid if the fund generates a return, which aligns the interests of the fund managers with the investors.
It's important to understand the fees associated with PE and VC funds before investing, but more importantly, investors should focus on the fund's actual returns, net of fees. As with any investment, due diligence is key to making an informed decision.