The Math of Private Equity: 2/20, 3-on-5, and 1-in-8

28 Pages Posted: 8 Mar 2012 Last revised: 21 Nov 2014

Marian W. Moszoro

George Mason University - Department of Economics; George Mason University - Interdisciplinary Center for Economic Science (ICES); Warsaw School of Economics (SGH)

Date Written: November 19, 2014

Abstract

Given the standard 10-year cycle of private equity (PE) funds, 2 percent year-on-year management fee on committed funds, and 20 percent carry fee charged by funds’ managers or general partners (GPs), a 3 times cash-on-cash return at disinvestment in 5 years is required to achieve median 15 percent return (IRR) for funds’ shareholders or limited partners (LPs). The implied 25 percent discount rate at which portfolio companies’ cash flows are valued is justified as exposure to non-diversifiable risk of failure. E.g., a 9 percent discount rate of a comparable company with a probability of failure of 1 in 8 yields a compound rate of 25 percent. Implications in turmoil times: (1) the 2/20 fee structure subject to cut down and evolution to dynamic schemes (e.g., on deployed funds); (2) EBITDA growth as the main source of PE return due to steady multiples and avoidance of over-leverage; (3) reduction of returns’ volatility by screening markets and sectors, and avoidance of carry trade risk. Conjectures: (a) sovereign funds weight increase as LPs, (b) market and sector specialization across funds, and (c) PE pitch switch from financial to managerial value added.

Keywords: Investment Decisions, Venture Capital, Private Equity, Investment Banking

JEL Classification: G11, G23, G24

Suggested Citation

Moszoro, Marian W., The Math of Private Equity: 2/20, 3-on-5, and 1-in-8 (November 19, 2014). Available at SSRN: https://ssrn.com/abstract=2017764 or http://dx.doi.org/10.2139/ssrn.2017764

Marian W. Moszoro (Contact Author)

George Mason University - Department of Economics ( email )

4400 University Drive
Fairfax, VA 22030
United States

HOME PAGE: http://economics.gmu.edu/people/mmoszoro

George Mason University - Interdisciplinary Center for Economic Science (ICES) ( email )

400P Truland Building
George Mason University
Fairfax, VA 22030
United States

Warsaw School of Economics (SGH) ( email )

aleja Niepodleglosci 162
PL-Warsaw, 02-554
Poland

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