bloggingbuyouts

If you believe the hype, private equity firms earn great returns by acquiring companies cheap and operating them more efficiently, and then often selling the leaner operations at a higher price.

But according to a study conducted at Wharton and written up in The Wall Street Journal, almost twice as much of their income comes from fees. According to The Journal, "The study shows that, on average, leveraged-buyout funds can expect to collect $10.35 in management fees for every $100 they manage. In comparison, slightly more than half as much -- $5.41 for every $100 -- comes from carried interest." (Carried interest is a fund's 20% cut from the profits of selling a business it has invested in.)

In theory, it doesn't really matter. Private equity investors can earn great returns regardless of how the firm takes its cut. But with the bulk of the firm's earnings coming from management fees based on assets under management, it gives the private equity funds a perverse incentive: they can make a lot more money doing low quality deals with $10 billion than they can doing better deals with $5 billion. They just don't have much skin in the game. The emphasis is likely therefore to shift away from operational improvements and quality deals and towards asset gathering, and finding deals to deploy the money.

How big of a problem is this? We'll know in a few years when we see how some of the deals from the private equity boom work out. If we see a lot of disasters and deals that appear to have been sloppily constructed and done at outrageous valuations, there's going to be a lot more complaining about the percentage of the money these guys take in management fees.