How private equity funds are compensated

When discovering private equity, one question often arises: how do funds actually make money? Many people imagine that their compensation comes solely from the capital gains generated when a company is sold. While this value creation is indeed a key part of their economic model, it is far from being the only source of income.

In reality, private equity management companies have several compensation mechanisms, some directly linked to investment performance, while others help finance day-to-day operations or support the companies in their portfolio.

Understanding these different revenue sources is essential to grasp how an investment fund actually operates.

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Management fees: the recurring income of management companies

   

The first source of income for a fund is the management fees.

When a fund raises capital from its investors, known as Limited Partners (LPs), they agree to pay an annual management fee intended to finance the operations of the management company.

These fees are used to pay investment teams, support functions, compliance costs, travel expenses, due diligence work, IT tools, and office costs.

The level of management fees varies depending on the strategy and the size of the fund, but it generally ranges around 1.5% to 2% of committed capital during the early years of the fund’s life, before gradually decreasing as the portfolio matures.

Management fees are therefore not performance-based compensation, but rather allow the fund to finance its day-to-day operations.

  

Carried interest: the real wealth creation engine

  

The most well-known mechanism remains carried interest, often simply called “carry.”

Unlike management fees, carry is directly linked to the performance delivered to investors.

The principle is relatively simple.

When portfolio companies are sold at a profit, investors first recover their invested capital, along with a minimum return called the hurdle rate in many structures.

Only once this threshold is exceeded can the management company receive a share of the gains generated.

In most funds, this compensation represents 20% of the capital gains generated, while the remaining 80% goes to investors.

Carried interest thus aligns the interests of investment teams with those of their investors: the more value the fund creates, the higher its compensation.

It is also this mechanism that explains why some Partners can receive very significant payouts after several years of value creation.

   

Personal investments by the teams

  

A often overlooked aspect is that fund partners themselves invest in their own vehicles.

This is known as GP commitment.

Partners contribute part of their personal wealth during the fund’s fundraising, alongside institutional investors.

They therefore also bear financial risk.

This practice further strengthens the alignment of interests between management teams and their investors.

The best funds often invest several million euros of their own capital alongside their LPs.

  

Fees charged to portfolio companies

   

Beyond revenues directly paid by investors, management companies may also receive compensation from the companies they support.

These fees can take different forms.

The most common case involves strategic advisory fees or monitoring fees.

In exchange for the monitoring performed by fund teams, their participation in strategic decisions, their support in acquisition processes, or their assistance in refinancing operations, an annual fee may be contractually agreed.

These practices were particularly widespread around fifteen years ago.

Today, they still exist in some funds, but their importance has decreased due to increased competition and higher demands from institutional investors.

In many cases, these fees are now offset against management fees to avoid double compensation for the management company.

   

Fees related to supervisory boards

   

Private equity funds frequently sit on the board of directors or supervisory board of the companies they own.

This presence allows them to participate in major strategic decisions, monitor financial performance, and support management teams.

In some transactions, fund representatives may receive attendance fees or specific compensation related to their mandate as board members.

However, in large institutional funds, these amounts remain generally modest compared to other revenue sources and are sometimes directly passed on to the management company.

The main objective of this role is not to generate additional income, but to protect the investment and support management.

  

Transaction-related fees

   

During certain acquisitions or refinancing operations, specific fees may also be charged.

For example, transaction fees related to deal structuring, acquisition execution, or coordination of different advisors.

Here again, practices have evolved significantly.

Institutional investors now demand much greater transparency regarding these fees, and many funds offset them against management fees.

This evolution aims to ensure better alignment of interests between management companies and their investors.

   

Why carried interest remains the main driver

   

Although management fees ensure the day-to-day functioning of a fund, they are generally not the main source of wealth creation for partners.

The real wealth generation comes from carried interest.

When a fund achieves several strong investments, carry can represent tens or even hundreds of millions of euros distributed among Partners.

Conversely, a fund that does not create sufficient value will not receive any carried interest, despite several years of work.

The private equity business model is therefore largely based on performance-based compensation, which distinguishes this industry from many other financial activities.

   

A compensation structure strongly aligned with investors

  

One of the core principles of private equity is alignment of interests.

Investors want teams to make long-term value-creating decisions rather than focus on short-term gains.

This is why the combination of management fees, GP commitment, and carried interest creates a relatively effective balance.

Management fees allow the fund to operate, partners invest their own money, and carry rewards only real performance.

The more the fund generates returns for its investors, the more the teams are rewarded themselves.

   

Conclusion

The compensation model of private equity funds is often more complex than it appears. While management fees ensure the daily functioning of the management company, the true economic engine is carried interest, which directly rewards value creation delivered to investors.

To these revenues are sometimes added advisory fees, monitoring fees, transaction fees, or certain board-related compensations, although these practices are now more regulated than in the past.

Ultimately, a fund’s success does not depend on the fees it charges, but on its ability to support companies, create sustainable value, and generate superior returns for its investors.