How to back up the truck in the leveraged buyout business

From the Wall Street Journal:

[A new Wharton] 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 [their share of the profits on the actual deals they do]…

The Wharton study draws from a unique trove of data, the actual performance records of a large institutional investor in private-equity funds. That investor shared data from 144 separate buyout funds from 1992 to 2006, with authors Andrew Metrick and Ayako Yasuda, both Wharton professors of finance…

In the 1980s, fledgling private-equity firms — with funds rarely topping a few hundred million dollars — charged investors a fee of 2% to 3% of cash under management. The fees were to “keep on the lights” — to pay the rent and hire assistants — before their funds generated any profit. Since then, multibillion-dollar funds have become common, and that management fee has evolved into a lucrative source of revenue. A $10 billion fund can generate $200 million a year for a private-equity firm just in management fees…

Now, what happens if the broad-based credit crunch dries up the supply of cheap debt for leveraged buyouts? Logically, leveraged buyout firms will still raise a lot of money from investors and do a lot of deals, but with less leverage, which will driven down returns on invested equity, which will drive down profits to investors, which will drive down carried interest. Which means that management fees will make up an even larger amount of private equity compensation than before.

Actually, it gets even more interesting than that. As the graphic in the Journal story explains, management fees and carried interest aren’t the whole story.

LBO funds also get paid “monitoring and exit transaction fees charged to portfolio companies” (fees that vary based on deal exits), plus “entry transaction fees charged to portfolio companies” (fees that are fixed based on deal entries). These fees of course also come out of the shareholders’ pockets, i.e. the investors who invest in the LBO funds. And they add up — in total, another $4.00 for every $100 managed. Which means LBO funds extract total fees of $19.76 for every $100 invested — of which, as noted above, only a little more than a quarter actually comes from carried interest, i.e. their actual economic purpose for existing.

What a business.