Zero-Sum Game
On Fees, Carried Interest and Incentives in Private Markets
What is your favorite pie?
If you love Excel as much as I do, the answer will be “Chart.”
Corny jokes aside, I’ll use the pie analogy to explain our zero-sum game. In this game, a pie represents the overall deal returns. If two players - 1 general partner (GP) and 1 limited partner (LP) - have to divide a pie, any time one person takes more, the other one will be left with less.
There is no such thing as a perfect alignment of interests between GPs and LPs, just as there is no ideal deal or fund structure. However, there are varying degrees of alignment, and different fee and promote structures create distinct incentives. As market conditions shift, the balance of these fees can become skewed, favoring one player over the other.
At the end of the article, I’ll provide a table with a break-down of common fees and structures we currently see in the market. That section, along with the rest of our archive, is only available to paid subscribers. Support our work: our newsletter the only independent LP voice in the sea of information provided by GPs!
Don’t treat this as gospel. There are excellent GPs who consistently generate above-market returns and charge high fees. Inversely, there are plenty of LPs who lost money on deals that had minimal fees and investor-friendly waterfalls. I urge you to look at deals holistically, and keep in mind the nuances of each situation. This is not investment, nor legal advice.
Overview
Fees cover operational costs of managing the fund (or property), compensate GPs for the cost of acquiring and managing assets, and ensure the long-term stability of the enterprise.
Carried interest (aka promote or performance fees) is a share of the profits that GPs receive when the fund exceeds a certain performance threshold, typically called the hurdle rate or preferred return. This incentivizes the GP to maximize the returns on investments for LPs. A preferred hurdle assures that GPs are only rewarded with significant compensation when they achieve strong returns for the fund.
In the world of private placement, things tend to vary quite a lot among GPs with lower assets under management (AUM), and converge to the following: 1-2% asset management fee, with 10-20% carried interest (aka promote) over a certain hurdle (7-8%) for funds with AUM ~$1B+.
(Mis)alignment of Interest
Perfect alignment of interests is impossible given the zero-sum nature of the game. However, there is significant variation in manager incentives, with some structures and fees leading to greater misalignment. As Charlie Munger famously said, 'Show me the incentive and I’ll show you the outcome.'
Below are 8 common issues where such misalignment can arise:
High Acquisition / Disposition fees (mostly in REPE) incentivize the sponsor to pursue more acquisitions instead of focusing solely on finding high-quality investments. This behavior can result in the GP prioritizing deal quantity or size over quality. Here’s an example of a REPE offering with egregious fees:
High Asset Management Fees: investors pay AM fees even if they don’t receive strong returns on their investment - and GPs are incentivized to grow AUM, with less regard for the quality of investments. Example:
