Private Equity Experience

Understanding Private Equity Management Fees in a Changing Market

• Emily Sander • Season 1 • Episode 3

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In this episode, hosts Ed Barton, Rory Liebhart, and Emily Sander dive into the world of management fees in private equity. They discuss how PE firms make money, what founders and management teams need to know, and the importance of understanding management fees in deal negotiations.

Key Takeaways:

  • Management fees are a crucial aspect of private equity investing, and understanding them is essential for founders and management teams.
  • PE firms use various fee structures, including management fees, carried interest, and carried capital.
  • Management fees can be a significant source of revenue for PE firms, but they can also be a major source of stress for founders and management teams.
  • Understanding management fees is critical for navigating deal negotiations and ensuring a successful exit.


Actionable Tips:

  • Founders and management teams should understand the management fee structure used by their PE firm.
  • PE firms should be transparent about their management fee structures to ensure a smooth deal negotiation process.
  • Understanding management fees is essential for navigating the complexities of private equity investing.


Timestamps:
00:34 Diving into Management Fees
02:56 Impact of COVID on Private Equity Funds
10:22 Current Market Challenges and Strategies
24:05 Navigating PE Firm Funding Challenges
25:48 Understanding Carry and Management Fees
29:36 Strategic Advice for PE Firms
34:35 Impact of Debt and Interest Rates

Who We Are

If we haven’t met before—Hi! We’re a team of professionals who’ve worked together at multiple companies, seen private equity from all sides, and are here to share what we’ve learned to help you succeed. Ed Barton brings decades of tax and financial strategy experience; Rory Liebhart is a finance and M&A pro with a track record of high-growth exits; and Emily Sander is a former Chief of Staff, multi-time author, podcast host, and founder of Next Level Coaching, helping leaders and organizations accelerate their growth.


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Welcome to the Private Equity Experience Podcast. Your backstage pass to the strategies, stories, and secrets that drive value in the PE universe. No filters, no fluff, just straight talk and expert insights to help you navigate the private equity world with confidence. And now your hosts, Ed Barton, Rory Liebhardt, and Emily Sander.

Emily:

We are back on the private equity experience podcast and we are going to talk about management fees. So we talked a little bit about how a PE firm makes money last episode, but Rory and Ed, what do you, what do I need to know? What do we need to know about management fees?

Rory:

Need to know I'm fresh in from Vegas. So if I come off as a bleary eyed idiot, uh, you know, I have an excuse for that. It's not my normal self. But it

Ed:

was a

Rory:

business trip. It was a business. There's all, it was all lots of private equity related discussions and hobnobbing. And it was a nice

Emily:

photo of you in front of that famous fountain or whatever. Yeah.

Rory:

Yeah. Yeah. The Bellagio fountains, Bellagio fountains. Yeah, exactly. Yeah. Yeah.

Ed:

You, you are, uh, You're the, the conference guy. If I never have to go to Las Vegas for a conference again, I'll be satisfied.

Rory:

It's just one of those things that it's a necessary, I won't say evil, but I'm too old for this stuff. I went to Vegas

Emily:

for three days. For a conference. And I don't think I saw a daylight once. That was how they get,

Ed:

it's brutal. It's brutal. Yeah. And what you're saying, Rory's the truth. And I'm that much older than you are. You just can't. I mean, you come back and you're like, I need a vacation for my man. I remember

Rory:

when we, we used to do it together. We used to conquer these things and it was a freaking marathon. Man. Yeah. But that's when I used to get buyer conferences. Oh, my.

Ed:

Yeah. Debt buyers know how to drink. Um, so yeah, and God blessed. Did I have to, I was able to back in the day, keep up, but I can't anymore. I

Rory:

remember Ed, one of the things you told me actually, when I worked for you back in that timeframe is, you know, if you actually, I think I was asking about, Hey, should I get into business development and sales? You're like, you need to learn how to golf and you need to learn how to drink. And I'm not very good at either of those. So maybe I'll just stick with finance and you know, all that stuff. So

Ed:

it's a, it's a safer, it's a safer spot pays better. Well, maybe not sales pays better. Yeah. But the two, the two crossover.

Rory:

I mean, that's, that's the, that's the magic there is some synergy amongst that. Yeah. Anyway, we digress as usual. So,

Ed:

yeah, I was, I was actually out while you were partying in Vegas. I, I was, I'd got something dropped into my lap, which was You know, we, we talked last, as, as you said, last episode about the, the fund structure and how private equity gets paid. And, you know, there's the, there's essentially the, the 2 percent of the asset management fee. And then they get, you know, essentially historically has been a two and 22 percent of the management fee. 2 percent management fee every year for what's being managed for assets under management. And then the 20 percent of the profits. Well, not 24 hours after we finished putting that, um, episode in the can, I see a, I see an article on PE wire that basically says management fees have fallen to their lowest level since tracking began. And you know, we're seeing, we're seeing That two is now like one and three quarters and a 20 in some cases is even lower than 20. It could be in the fifteens or, or, or tens. And I was having a, another discussion with a friend of mine in private equity this last week who said that the funds that were raised during raised and deployed during. Essentially during COVID and post COVID 20, late 20 through early 22 are just performing like dog shit. And they're having problems kind of showing return to, and to the LPs are having problems raising the next funds. And of course, We haven't gotten to that part in kind of the series yet, but that's how private equity stays alive. And so I'm curious, you know, what kind of, whether you were hearing anything in Vegas on, on kind of these issues and, you know, what, if anything, It might portend for private equity, both for founders and for, for PE, uh, GPs and LPs, you know, going forward.

Rory:

Well, I got a lot of questions along these lines and had numbers discussions, not only about, you know, what, what, uh, you know, what does the economics look like for private equity funds today, venture funds, et cetera, but also, you know, what, what does the capital raising environment like and how is that? How's that going? I think there's a few factors at play, you know, one you touched on it is some of these vintage funds from pre COVID or, you know, some of that are long in the tooth from, you know, 21, you know, this isn't the best M& A environment that the world has ever seen. Right? So, you know, this is about the time where that vintage is starting to harvest and sort of divest and sort of take shape. Take profits off the table and basically start to, you know, wind these funds down, move on to the next. Now people are still raising funds, but they're extending the old ones or the, the more, you know, uh, the vintages past the typical three to five year timeframe to, to longer periods. So what does that do? You know, that makes for a little more fundraising challenge because typically you're LPs and like, remember last episode, we talked about LPs being those. Pension funds, endowments, sovereign wealth funds, you know, insurance companies, et cetera. And if their money's locked up in one fund, it's sometimes it's hard to get more money out of them. And I mean, anyone that's been in the business of raising capital, whether you're a founder and a venture backed fund or whatever, or your, your own operating company, if it's hard to go back to the same well, if you've not delivered them their original investment back, you know, so, so I think that's put some strain, you know, there's still a lot of capital on the sidelines, but, um, but it's, it's, you know, in order to, to, to raise funds in an environment like that, you, you do need to kind of, I guess, quote unquote, get creative on fee structures. So yeah, it sounds like fees have come down. Some of that also, I think has to do with scale. The bigger you get, you know, it's just a lot of large numbers, you know, charging 2 percent on, you know, a 20 billion fund, you know, or, or 100 billion fund or whatever. Um, it starts to look much more like a mutual fund size where those fee structures are, you know, 25 to 50 basis points, not, you know, 200. So there's a lot of factors at play, but yeah, I think, you know, for a lot of middle market private equity funds, um, you know, that could be a big. Is it, because they're If they're having to take a hit on the fees, you know, hopefully profits,

Emily:

how big of a deal is it? I mean, obviously 2%, 1. 7, 5%. I think you said on that amount is a lot, but it was every single deal right at 2%, or was there a little squishiness around the edges?

Rory:

But there's always been, yeah, there's

Ed:

always been some squishiness and and some of the funds. You know, Emily, if, if it's a real specialty niche, they may be up in the 2 percent to 5 percent range

Emily:

and, and

Ed:

for others where it might be a debt fund, um, or leveraged, leveraged loan fund, they may be sub 2 percent or have historically been sub one down to 1%. So it has varied, but the, the mentality has always been, you know, two in 22 percent for the, for the Um, kind of base management fee and 20 percent for the, or for the carry, the, the part that's, you know, kind of based on profit. The interesting thing is probably, you know, 20 years ago. So back when I was getting started, um, that two and 20 turned into two and 20 over. So you only get your 20 percent over a hurdle rate. So you kind of got to go, okay, it's two and 20 over 12%. So, you know, you, once you get the first 12 percent back to the limited partners, then you start seeing your, your carried interest or your carry start, start paying off. And I think, you know, what, what we're seeing in the market and I'll give a, I'll give a kind of a. Real life example here in a minute what we're seeing in a market for my seat is like, look, the, the debt markets suck because the interest rates are high or historically, they're not historically high, but relative to the last decade, they're high. So it's tougher, you know, kind of finance geek, you're kind of. Pricing these things on a discounted cashflow basis and your discount rate or your risk premium, or however you want to describe the, the way you're valuing the business is driven by, is driven by a higher required return because interest rates are high. So that drives prices down. So the market, you know, sellers are more reluctant to sell because the valuations have gone down. Companies who are bought when the, Interest rates were 1%. Now interest rates are five or 6 percent are going, you know, our, the company's got less value, even if we've grown it, it may have less value today than it did when we bought it. So it's tough for the PE guys to get out of those companies or certainly get out of it at a profit and the. The leverage piece that they use. So when they do the financial engineering and throw some debt on for the acquisition, that, that carry is getting more and more expensive, which reduces cashflow. So, I mean, it's, it's kind of a, uh, I don't want to say it's a perfect storm, but it's a, it's a rough market out there and the, the LPs are going, Hey, we, we want, it's our money. We want our share. And yeah, you might not be seeing a lot of that promote because you're not going to hit the 12. Bye. On the next fund, you know, you owe back to us a little bit. And so we, we're going to take that, you know, that why is the distinction

Emily:

between the debt market important?

Ed:

So the debt market, the debt market does two things. And, and the, the first thing kind of as a practical matter, the first thing is. A lot of the private equity funds will borrow a portion of a purchase price. And so, and they, when they buy the company, they go, Hey, we're going to use some of the cashflow from the operating business to pay this debt down. Yeah. But a service to debt. Well, most of the time that debt isn't like, you know, if you go buy a house, you got a fixed rate mortgage, it isn't fixed rate. It's variable rate. And they may or may not have hedged. You put a, put a hedge on to protect their interest rate exposure. So in some cases or interest payments may have gone from 80, 000 a month to 270, 000 a month over the last few years as interest rates have risen, which comes out of the operating cashflow of that business, which limits our ability to reinvest, to grow, you know, to, to spin off dividends. So that's one piece. The second piece is. A principle of valuation of any company is kind of this concept of, I've got to get a certain return. And that certain return is again, going to like finance theory, a risk free rate, plus the, plus the risk premium based upon the riskiness of that particular asset. Well, if the risk free rate That's kind of driven by the bond market, the government bond market. So if government bonds have gone from a quarter point to two and a half percent, the required return goes up by that same amount by, you know, another two and a quarter percent. And so now the discount rates higher and the business's valuation goes down, even if the business is doing just as well or better, the valuation goes down.

Rory:

Translation. Not the greatest thing in the world to founders, management teams, looking for some compensation on a company valuation. And not right now, in a way there's a lot more, uh, cooks in the kitchen and there's a lot more hurdles to be cleared before you see that dough, uh, you know, down the waterfall, as you say. So, yeah, I mean, so kind of going back to that comp and, you know, compensation piece of it, you hit it like, you know, the, the, the, the firms that have a specialization. Can still command the higher management fee. Like, um, you know, I have a couple of, I guess you would call them, uh, closed end, private equity funds that acquire assets that are in bankruptcy. So we do something extremely nichey. We're able to charge, you know, two and a half percent, but, you know, we have investors that'll see headlines like what you talked about and say. You know, uh, I I'm seeing now that the going rate for AUM fees is one, one and three quarters. So like, why are you charging two and a half? So that, that becomes a discussion that a fledgling, you know, fun like ours has to navigate. Whereas people see kind of these macro trends and like look at it and compare it to a, you know, a quarter, quarter trillion dollar fund. You know, it's, it's a, it's a British it's it, this doesn't bode well for optics around small. Funds like this. So it's you got to specialize. Um, and that's, that's key in order to be able to kind of

Emily:

like the standard is changing. It sounds like

Rory:

it's, it is more at a rat more rapid clip perhaps now than it had been is, you know, it's always kind of been this. Baseline two and 20 concept is we've talked about that seems to have been the standard for many, many, I mean, decades even. Um, but yeah, now it's just, it's, you know, there's, there's different shifts in leverage, right. And in which side of the deal you're on. So, um, right now LPs have the capital, um, and there's more choice. And so, you know, the sponsors, i. e. the private equity funds have to make concessions. That's just how it goes, you know? So,

Emily:

so how does this compare with like the deals that, um, We've been a part of, or you two have been a part of, like, you mentioned the different structure. I mean, what do you have to structure differently?

Rory:

So there's a, there's a few things I think, like in this particular article that we were looking at, you know, I think that the denominator for which, The fees are measured against, you know, is the commitment amount, right? So if, if a LP commits a hundred million dollars to a strategy, in this case, we're talking about charging one and three quarters percent against that committed a hundred million. What's the difference between committed and called it means if I've signed on the dotted line as a commitment, it means that I'm reserving capital to be called by the private equity group at any point in time called means, Hey, we're going to go buy a deal. You need to fund your commitment. So, so different flavors dictate kind of how the fee structure works. I think like. The charging fees on the commitment itself is very private equity fund friendly, not as friendly to the LP. Whereas other, other strategies say, we're only going to charge you a management fee on the capital we call. I mean, that's what my fund does. We, we don't call, we don't charge a management fee on commitments. We put it on ourselves to say, if, if, if, if, if, if, if, If we don't do deals, we're not earning a fee. So, you know, there's different flavors of that. So two and a half percent that we charge. Might sound high, but it's lower, relatively speaking in the event that, you know, we're compared against some that are not actually calling all the capital deploy and deals. And so we talk about the M and a environment. The reason you're not, there's just not as many deals happening. So they're not as much capital being called. So private equity funds are saying, Hey, we recognize that we're not calling and investing as much of your capital. Maybe in this, this case for this fund. We'll seed the rate on what we charge so that you don't, your capital doesn't fly from our fund to some other strategy, you know?

Emily:

Holy cow. Okay. So like if I'm a founder, I am like thinking about this at a couple of different levels, like like macro economics. It's like, what is the market doing? Like what are interest rates doing? Um, or is there any like crazy events happening that would move the market at that level? And then it's like, what PE fund am I working with? Are they Are they large, medium, small? Are they boutique or specialized? Who makes up their LPs? And what are, what, what's happening at that level? And then of course, for what's important to me as a founder is like, how does that affect my deal structure and how the PEs? Exactly right.

Rory:

Yeah. I think what you're hitting on is really important for a founder and management, again, working with a founder and these operating businesses, like You know, what is that dynamic behind my potential investor? Right? Like my potential private equity, what is their dynamic look like? You know, you know, look like if you're, if you're dealing with an Apollo, you know, there's nothing to worry about, they're pretty solid, but if you're dealing with a fledgling, you know, um, PE group, that's sort of at the table, maybe, you know, really aggressively courting you, but it's hard to say. Just how, you know, how, how deep of a track record they have, what their LP situation is, that's something to be cognizant of for sure, because your success is going to be based on their success. I was going to

Ed:

say two other things to keep in mind from a timing perspective right now is, um, You know, as I had mentioned, the, the purchases that they made during COVID, so 2021, 22, before interest rates started to rise, they're underperforming on balance. So if you can, so if you can afford to not sell again, a Pete, the private equity guys have long term relationships with their limited partners. And if they got a couple of funds that aren't doing well, they're going to be looking to get. Their next fund to do really well. So they're less likely to be paying you top dollar. They're less likely to, to be as aggressive. They need to get deals done, but they're going to be looking to hit long ball on this stuff versus versus small ball on the other.

Emily:

Can you outline like a, at a high level? What a deal looked like pre COVID or during COVID and then do one for now.

Ed:

Yeah, I'll, I'll give an example. We, we were working on a deal. I was working on a deal with a, with a family office out of the Bay area about almost two years ago. And we were prepared to pay like 16 X EBITDA on a, on a manufacturing and distribution business, which again, made me a little bit, You know, as a, as a hardcore finance guy, a little bit, yeah, but we did not get that deal. We were outbid by a private equity firm. Yeah. We were outbid by a private equity firm. So it was a, it was a family office and it was, and we were outbid by a private equity firm. That same deal today wouldn't trade at more than 11.

Emily:

And I'll bet you

Ed:

it would possibly be single digits and the folks who bought it are not happy. We happen to, you know, maintain contact with a couple of managed members of the management team and you know, they're, they're not happy. And the issue there is, you know, in order to get the deals done, there was a lot of capital running around, interest rates were low and folks were trying to get. Capital deployed. And so they're like, okay, well, we'll, we'll buy with the anticipation that growth is going to continue. Well, you know, the economy slowed a bit, interest rates have risen, their carry cost has gone up. And now that business is worth significantly less. And again, if you go from 17, 18 X down to nine X. That business, the same business performing the same way, the value has dropped in half. So are we still, are we still

Emily:

talking, are we still talking about the management fee or, or the fact that PE firms have different funds that are open? Well,

Ed:

well Pete, so it's a combination of things. So let me take a step back. These funds that were opened. In 2021, 22 are underperforming today. So when the PE guys are going hat in hand to their limited partners are going, we need money for the next fund. Yes. The limited partners are going to, they're saying two things. One, those other funds aren't performing well.

Emily:

Yes.

Ed:

So you need to cut me a deal on this one because I'm not making as much. And two, whatever you're doing in this fund had better be better. Better than the crap you did in these last couple of funds. And so if you were a founder founding management team, this is probably not the ideal time to be selling. Because the private equity folks need to be able to kind of recover their performance, hit their performance targets. They need to pay less. The interest rates are up. So they're going to be, the multiples have gone down. And as a, as a management team member, you may be better off going, okay, can I, can I push through for another year or two until interest rates come down before I go to market?

Rory:

Yeah. So, I mean, that speaks to a few things, you know, um, private equity. Again, you think about these things as I'm buying company, a company, B company C on a, you think about it on like a singular basis. But at the end of the day, these are parts of a portfolio. So these, these, these, these cumulative deals are looked at as part of an overall portfolio. So if you're over performing on one part of your portfolio, you're trying to make that up on, let's say, investments today that offset that. Right. So ergo, you're paying, you're trying to buy deals. At a steeper discount basically. Um, and so, you know, for, for, you know, touch, you touched on sort of the environment spell, maybe not ideal, but shoot, it's still more ideal than trying to go public right now. You know, that's right up. So I think the theme that we've, we've talked about in our book and we touched on even last, last podcast, I think a little bit was like private equity still is in many ways. The most frictionless way to realize value on a business you've built, you know, so All of that to say like the private equity group's always going to be trying to You know figure out how to make their own money both on the LP side and the investment side Because they make most of their money, of course still on the profitability of these businesses so, you know, it all works together, but I just think that right now is an interesting time because You know, we have been in this high interest rate environment, you know, political uncertainty a lot, a lot of money on the sidelines still, but you know, it's almost like the skids need to be greased to get the whole system working as efficiently as we've been used to over the last top 10 to 15 years, really, you know?

Emily:

Okay. So if I'm a founder and now I understand, all right, I kind of have to be aware of what's happening. Not like directly impacting me, but like indirectly it is. I'm going to try to break down what I think I just heard. So during COVID PE firms made investments in funds and those companies underperformed because COVID sucks. And so when they open, okay. Someone give me like the 10 sentence answer, 10 second answer of like why they underperformed then.

Ed:

They, they underperformed because interest rates went up and they overpaid for them during COVID.

Emily:

Well, okay. So interest rates were going crazy because of COVID was doing what

Rory:

you're talking about. Emily is actually, you know, a double adding, calling it, it creates a double negative. So like Ed was talking about it as if like business is performing just as it was, but what you're talking about actually makes that even more of a hit, like a negative, it was like

Emily:

a double stacked against your environment. So then when PE or when PE firms go LPs. We need some more funding for the next round. Come on down. They're like,

Rory:

my money's still tied up that checkbook right now. My money's still

Emily:

tied up over here. It's not doing so well. So I want a discount on this other next round.

Rory:

Yeah. Buy one, get one at a discount. Exactly. Just like you'd go to the grocery store for, you know, whatever, whatever you like, you know, that

Emily:

makes sense to me. So then the PE firms go, okay, I'm going to go from 2%. To 1. 75 on your management fee, they go, okay, fine as a founder, I need to be aware of that. Is it more so for like trying to exit? Is it more like, where does that affect me most?

Ed:

So as a founder, it's less, the effect is less direct. I mean, you're not being impacted by the LP fees. You're not being impacted. What you need to be aware of as a founder is that private equity fund is under tremendous pressure to perform right now, more pressure than they've been under for a decade. And so

Emily:

they're going to

Ed:

structure their deal to ensure better

Rory:

performance.

Emily:

Ah, so on again, remember this is kind

Rory:

of a zero sum game. Any gain on one side means, you know, seeding something on the other side. It's, you know, you can't, it's not a perfect hedge, right? So

Emily:

you're going to get. In general, statistically speaking, you're going to get a less favorable deal on your end. Because they're going to try to make up for it.

Rory:

Correct. Yep. Yep. Exactly right.

Emily:

So they're getting crunched on the LP side. So they're going to try to make that up on your side.

Ed:

Yep. On the carry.

Emily:

On the company side. Okay.

Rory:

Yeah.

Emily:

Rory, can you break down carry? Can you break down what edges? Sure.

Rory:

No, it's just, we'll, we'll keep coming back to this, you know, in, in these carry carry simply means. The private equity groups call it participation in the profitability of the business. So like if, if they, if the business is sold at a really good price, then private equity group participates in the profits that are delivered to the LP from that. Deal being so good. So like, here's the, here's how it works. Like on my, my fund, you know, we have a, we have a participation. Once our investor groups hit a 10 percent return. So any, anything above a 10 percent return, we participate, it's called carried interest. We have an interest that we have in, in our investors profitability, basically. So we share in their profits. So

Emily:

if it hits that threshold, you get interest payments. Yeah. Like are they, are they like dividends or are they just like, you get. Yeah.

Rory:

Yeah, exactly. It's it's, I mean, technically it's just a share of the distributions, but it's, you know, how you, how you characterize it, just think about it as participate in the cashflow, that's the easiest way to think about

Emily:

it. Now, can, do you have the option to reinvest those in the business or do you pocket them or do you have choices?

Rory:

Yeah, I think, well, so depending on the structure of the fund, you know, oftentimes there is reinvestment or at least for a period of time, like in our Our funds, there's a, there's a period that's just the investment period. So any dividends or I should say cashflow that's available to be distributed, gets reinvested in assets for a period of time, but not forever because, you know, as an LP, eventually you want to see, you want to see some cashflow, right? You know, so that's, and that's the whole purpose of it. So. Yeah.

Emily:

Okay. Okay. I'm still trying to like, find a succinct way to say, why are these management fees falling? Because it made the news. Like, it made your

Rory:

I think it's more relevant just for people in the private equity side of the coin. Not, it's, as Ed said, The impact to founders, management teams, people in operating business. It's indirect. I think it's just interesting because we're sort of seeing a trend that's been different than what we've seen for many, many years. And anytime you see the market going rate for asset management fees under private equity managed funds decrease. That's a, that's a big thing because it's been such a ubiquitous two and 20 dynamic forever. So you just naturally want to think about, well, what happens now? You know, like, what does that mean?

Emily:

Can it go back up? Yeah,

Rory:

absolutely. Absolutely. You know, one thing that's certain about private equity and the very, very smart people that are in that world is they innovate, they figure out ways to create new value, create differentiation. Like Ed said earlier. You know, if you're a specialized fund, you can command higher fees. Some of them, and this is kind of in hedge fund territory, but I mean, some of the hedge fund fee rates are really, really high because maybe they're, you know, high frequency trade. I mean, just super specialized stuff that somebody is willing to pay for, you know, because it's high value and you're delivering high returns. At the end of the day, it's all commensurate. Remember this, this is as basic as it gets. Fee structures are aligned to investor returns. It can't be out of whack. Otherwise there wouldn't be a business. So best returns go up, then, you know, private equity makes more money because, you know, everyone is happy when they're making money. And so you can command more fees. If it's, if it's tough environment to realize ROI, then fee rates have to go down. It's just the law of supply demand, you know?

Emily:

So to turn the tables a little bit, if you were talking to a PE firm or like a managing director of a PE firm in this environment, and they're asking you how to, like, what do I do, how do I structure this, What advice would you give them?

Rory:

Ed, you might take that one. You're a master structure.

Ed:

Yeah. Master structure. Um, you know, if I were sitting on the other side going guys, the right now, it is a, It is a buyer's market, um, for businesses. So PE firm, if you have skinnied yourself down, you may want to go, Hey, I'll take one, one and a half percent, one and three quarters on the asset management fee, but I'm going to push the promote up, or I'm going to push the carry up to 25 or, you know, 22 so that. I'm more aligned with the limited partner. So I make more money when the only one, the limited partner makes more money, but I'm going to make up the difference in on the profit side. So I'm not giving up the dollars. I might just be deferring them with a potential of a higher up if I really perform well.

Emily:

Okay. So I got one point higher

Rory:

upside on the percentage profit share, the carry, as we talked about maybe lowering the hurdle rate too, for which you start to get compensated. I mean, a lot of times. You know, it could run the gamut. Like I said, our funds are like 10 percent is our hurdle rate, but I've seen funds as low as five. So, you know, you'll find, you know, if you, if it's a, let's just say if it's a tougher environment to make money generally, then a lower hurdle rate for which then, you know, the PE group can share in the profits of the LPs makes sense, it's just, you know, there's a baseline economic. State of affairs and everything like, you know, risk free rate, all this stuff is benchmarked around

Emily:

that

Rory:

effectively. I mean, like it's all, it all works together. You know,

Emily:

sounds like, like you're still being incentivized. It's in alignment with the LP it's just, yeah, I have to like reach out. If you're not, if you're not, there's no business around kind of where and when that happens and how that happens. Would you like, Ed, would you suggest the PE firm does anything specific with like the, the companies they're working with on that side, or is it all kind of rejiggering with, they're

Ed:

going to, they're going to be working. Um, you know, on that side to refinance, re engineer, renegotiate, um, renegotiate covenants and they give themselves some flexibility on the debt side for their existing, for their existing portfolio companies. The new companies are taking on, they're going to lever, they're going to lever them differently and are going to go in with a different strategy that isn't necessarily a debt driven, uh, debt driven strategy. Optimization value optimization model, because it may not be, they're probably going to be looking more at what kind of operating efficiencies, what kind of growth, what kind of organic growth can we get out of this business more so than, you know, how much of that can we throw on this to be able to drive the return on equity up?

Rory:

Oh, I was just going to bring it back to kind of like. Once again, talking about, you know, the ability of an operating company to be more and more profitable just means more and more value to, at the end of the day, the LP that's, you know, committed, committed the capital, the PE group who's invested it, I mean, it all, it's all this virtuous thing. Like, so is that saying you do all these things at the opco level so that you can. Make it more profitable for the PE group and then the PE group can share in more profits, you know with their circle

Emily:

of life Simba Everybody wins

Rory:

is it's a sir. It is the circle of life for some the circle of death, you know You know it it is it's you know It it is really just it's always just these pieces moving within this ecosystem. That just says okay where is Where's the benefit going at the end of the day, it's always going to be aligned to the benefit or at least structured in a way that the LPs, you know, make the money. I mean, cause without, without their money, none of

Ed:

this, nothing happened straight up at the end of the day, though, M it's gotten harder. So, I mean, fundamentally it used to be when you could borrow money for 3%. Yeah. You go, okay, this is easy. I'm going to, I'm going to pay as little as possible. I'm going to put some leverage on the business. I'm going to get a good return on equity and it's done. And if you don't achieve the operational efficiencies, if you don't really grow, you can still get a decent return out of that business. Now. The strategy going in and we talked about, you know, private equity goes in with a strategy. They're never like, well, we're going to buy it and see what happens. I'll bet you dollars to donuts at that strategy right now is far more driven around, how do we drive operational efficiency? How do we drive organic growth? How do we be capital efficient and not as much about how do I throw debt on this business and service that debt to be able to. They kind of bring my purchase price down and get a higher return on equity. It's got to be more on the operational side.

Emily:

So is the main form of debt in what you're talking about a bank loan?

Rory:

Yeah, it's normally bank loans and nowadays private credit funds. So non bank lenders, but yeah, it's, it's the, let's just put it this way. Uh, Emily, the, the, that's called the credit markets. The, the world of debt is orders of magnitude bigger than the private equity world. It's, it's massive. Because

Emily:

like earlier Ed said, covenants and I had like flashbacks. So it's like you and Rory and Glorimar and like our PE firm, like we're going to bust covenants. And that was like the end of the world. No, it's a little bit gnarly

Rory:

at times like this, you know, you know, it's like a little more You know, a little bit, little hairier, you know, but you know, yeah, but that's just the cycle of business. It's a cycle of life, right? Like it's always cyclical, but also

Emily:

like in that the interest rate affects the bank loan as well. So it's kind of totally like the macro economic piece of it. You have to be aware because it hits you in these different points. There was

Ed:

a, there was a lot of folks that back for the last few years, They didn't put interest rate hedges on because they're like, well, you know, it's going to be fine and it costs money to hedge your interest rates. And so they were like, no, we're getting, we see stability. Well, all of a sudden the interest rate starts taking off and they're like, well, and it took off fast. I mean, the interest rates rose quickly and they ended up flat footed and now they're stuck with, you can't hedge against, you know, they're hedging at 4%. Didn't the

Emily:

interest rates go negative in certain countries somehow?

Ed:

Yeah. The, the, like the equivalent of the fed funds rate, but, but yeah, the effective, the effective interest rate was so low that a lot of, and again, every one of these things, if you're going, well, I'm going to hedge my interest rates, you have to buy the hedge with the bank. You negotiate it with the bank. So folks are like, well, why would I want to spend that money? I don't see the interest rates going up anytime soon, so I'm going to, it gives me a better return. Well, it's crazy. Let's. When he flipped that really

Rory:

greediness, like in like

Ed:

just a couple of quarters, the interest rates went way up, like very quickly that caught a number of companies that didn't have a hedging strategy flat footed.

Rory:

Yeah. It's, you know, like it always follows the same thing. It seems like, you know, there's, there's, there's these cycles go to where. You know, I don't know, like there's a level of complacency at a certain point. Things are so good. There's no way it could possibly swing so far the other way that we get slapped. And then, but sure enough, it does. And you do that's a. That's a, I, I think corrections like that are critical, you know, and that, but it happens, you know, um, it just, it's, it's, it's a normal part of thing. It's

Ed:

almost like every 10 years, like clockwork. Yeah. I was just going to say that I was trying

Rory:

to do the, you know, kind of, and I'm sitting here, you know, I've got, I got gray hair, so I've

Ed:

been through like four of these and I'm like, you know, it's about every eight to 10 years, like clockwork, the, the, the Business cycle cycles and folks like we never saw it coming when it were, as you're getting old, you're like, no, I can see this. I see it coming. And you guys are coming now.

Rory:

Yeah. So you never know. Like we could be sitting here 10 years from now saying, wow, management fees on average are 4%. Why is that? Well, it's because. Blackstone and KKR have acquired every other private equity firm in the world. And it's only two of them, and now they have the pricing power. You know, who knows? Like, there's, there's, uh, these things can swing both ways if you, if you want to

Emily:

think about it. So let me like wrap this up and almost like it's a tee up for a future episode. But

Rory:

yeah,

Emily:

for like the debt side. The P. E. firm. Ooh, I love talking

Rory:

about debt. That's my favorite.

Emily:

You get so excited. I do. So the P. E. firm, when they're, when they're doing a deal, they'll take out a loan from A bank and the terms they negotiate with them are key to how the deal is structured as a, as a founder, you best be aware of how that's structured, because if like the interest rates do a whole, like a rollercoaster on you, that crunches your forecast. And that means you're going to have to operate differently. So that's like a whole other, we have a

Rory:

whole section of that in our book, you know, plug, but yeah, But yeah, that's, that is, you know, you mentioned what's, what's direct and indirect effect on these businesses. Absolutely. The leverage that's so leverage equals that again, um, that's placed on these businesses usually at the time of acquisition by a PV group, that, that is directly impactful to the founder and what they've been used to 100%.

Emily:

They're at

Rory:

the

Ed:

top, they're at the top of the waterfall with the best Vista.

Emily:

Yeah. Well, I mean, they get, they get paid first. And I know that in some scenarios, like if you're, if, if the company is not doing well and you're not able to pay back the bank, they'll extend the loan to you, but the interest will be higher. And so it almost makes it worse. And they'll

Ed:

charge you a fee for the privilege and see what the, what the business, what the bank does not want. Every

Rory:

time a covenant is waived that you've busted

Ed:

or whatever, you get charged for that. Write a check. Yeah. Yeah. What they will not, what they do not want to do, and this is a whole nother episode is take the business. So they don't want to force you to bankruptcy. They don't want to take the business. They don't want you to toss the keys at them, but they will extract every pound of flesh that they figure they can, including renegotiating that loan in order to be able to make sure they get paid back and, or by, or, and again, we've been in, I've been in this situation once where negotiated with the bank to buy us time to get the company sold. Yeah.

Rory:

Yeah. Or basically, you know, put it to the ownership group to put in haircut money, right? Like to top up. So that if that means, you know, we talk again, prefacing some of the book, we talk about concepts like drag along tag along, you know, if you're, if you're in an ownership group. And you're, you know, you're, you're a party to a bank loan. You know, there's, you, you may need to contribute more equity at some point to, you know, um, top up if you're using a borrowing based scenario, like the advance rate, I mean, that's, this is a whole nother episode, but yes, these are absolutely things that a founder and the manager team need to be. aware of and understand deeply, um, in these deals. So, so basically

Emily:

listener, you have gotten a preview of an upcoming episode. So if you would like to know more than tune in next time to the private equity experience podcast, Ed Rory, anything, any last thoughts on management fee or what that means or what people should know, why that's newsworthy. We covered a lot. We covered

Rory:

a lot. We jumped around. Um, Not really. I think, I think, uh, yeah, I think it's important for us to just kind of keep on current trends and look ahead. And what does it mean for, what do these trends mean? I guess that's the, that's the point.

Ed:

Yep. And I think second, third layer effects of, of what you're seeing in the headlines. Yeah.

Emily:

Yeah. And I think, you know, We're going to be doing episodes on the trending topics. And if one of us comes across a new story that we think is important for you to know about, then we'll kind of discuss it as a group here and you get to listen in. But,

Rory:

and if you viewer or listener have interest in things that you're seeing and you'd like us to expound upon, we love doing it. So hit us,

Emily:

shoot us a note. All our information is in the show notes as always. All right. Talk to you guys next time. Bye.

Rory:

Bye.

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