Valuing Complex Derivative SecuritiesValuing Complex Derivative Securities

Even though private equity fund managers are in the business of sourcing and investing daunting amounts of money into a variety of private companies, their mindset often resembles that of the businesses in which they invest. In their 2015 Annual US PE Fund breakdown, Pitchbook identified the average size of a PE firm in 2015 was $177,000,000. Assuming a pretty standard annual management fee of 2%, the fund manager of an average PE fund in 2015 “earned” $3,540,000 of revenue from management fees…and probably close to $0 in free cash flow. This is because they spend their revenue like most small businesses; on human resources, rent, travel & entertainment, infrastructure, capital formation with potential investors, and marketing to potential portfolio companies.

PE Fund managers typically don’t achieve “free cash flow” until they begin to harvest their portfolio company investments 5-10 years into their fund’s lifespan. On top of that, unlike most business owners, they typically don’t get to participate in the profits of their labor until their investors first recover a preferred annual return somewhere in the neighborhood of 8%. Said differently, on a $177,000,000 fund, they have to return $14,160,000 per year before they can participate in the incremental profits of the fund! For a $177,000,000 fund, that’s about $70 million over 5 years!

While the image of a “vulture” private equity firm descending upon the salt-of-the-earth family-run enterprise has become ingrained in pop culture and the political discourse, the fact is that the vast majority of private equity firms are run just like small businesses too. Entrepreneurs should keep this in mind the next time a Private Equity fund contacts them about a prospective growth investment or buy-out.

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