The buyout industry’s deals in 2006, 2007, and 2008 are disasters, of course–hosing lenders, equity holders, and buyout-firm shareholders alike. But no worries: the industry’s fee structure ensures that Blackstone, KKR, and other buyout employees will get paid while investors take most of the pain:
Barrons: INVESTOR AGREEMENTS GENERALLY ENTITLE private-equity firms to collect base management fees averaging 1.5% a year based on committed capital, not the original cost of investments or their fair value. The clock starts ticking when the fund is launched, even if all the money hasn’t yet been put to work.
Catch that? When a firm like Blackstone launches a $10 billion fund, the folks who ponied up the money start paying the firm $150 million a year in fees even before the firm starts putting the money to work. They then continue paying this $150 million even if Blackstone blows all the capital on stupid investments.
Yes, if Blackstone makes terrible investments, the firm will eventually suffer, too, because the fee agreements also entitle Blackstone to 20% of “profits.” But the “1.5% on committed capital” arrangement is the sweetest deal in town.
Even hedge funds, which are often paid astronomical amounts just for market appreciation, don’t have it this good. If a hedge fund blows you up, its management fees will be henceforth be calculated on the lower asset base, so the firm’s principals will feel the pain. Not so in Buyout World. You’ll pay the full fees on your money even if it’s gone.
But don’t blame Schwarzman, Kravis & Co. for this ludicrous arrangement. Blame the suckers who signed up for the deal.