A Model of Private Equity Fund Compensation

Private equity funds are typically organized as limited partnerships, with private equity firms serving as general partners (GPs) of the funds and investors providing capital as limited partners (LPs). These partnerships usually last for ten years, and partnership agreements (investor contracts) signed at the funds’ inceptions clearly define the expected GP compensation. Since the payments to GPs can account for a significant portion of the total cash flows of the fund, the fund fee structure is a critical determinant of the expected net fund returns that the LPs receive. Metrick and Yasuda (2010a) estimate the expected present value of the compensation to GPs as a function of the fee structure specified in investor contracts, but do not consider the fair-value test (FVT) scheme, which is a commonly used carried interest scheme in practice.1 In this chapter, we evaluate the present value of the FVT carried interest scheme by extending the simulation model developed in Metrick and Yasuda (2010a), and compare the relative values of the FVT carry scheme to other benchmark carry schemes.