Evolution of PE/VC Fund Terms Beyond 2 and 20

Case Study: Evolution of Private Equity or Venture Capital Fund Terms Beyond 2 and 20

Background

Private equity (PE) and Venture Capital (VC) traditionally operates under the “2 and 20” model, where general partners (GPs) earn a 2% management fee and 20% of profits (carried interest) above a certain hurdle rate, typically 8%. This model, designed to align the interests of GPs and limited partners (LPs), has long been the standard. However, recent market trends and pressures have spurred a re-evaluation of this structure.

Problem Statement

The increasing size of PE/VC funds and changing economic conditions have exposed weaknesses in the 2 and 20 model. GPs have increasingly relied on fixed management fees rather than performance-based incentives, leading to misalignment with LPs’ interests. This concern has been exacerbated by the rising cost of capital, inflationary pressures, and a significant reduction in deal-making activities since 2022.

Current Methodology

The current study builds on an analysis of recent developments in the PE/VC industry, looking at changes in fund terms due to factors such as market volatility, higher interest rates, and a sharp decline in deal-making and fundraising activities in 2023. This includes the growing trend toward larger, more concentrated funds and the emergence of innovative fund structures aimed at better aligning GPs’ incentives with LPs’ expectations.

Key Findings in 2023-2024

1. Shift in Fundraising and Deal Activity: Fundraising in 2023 saw a notable contraction, with a 20% drop in total capital raised from 2022, the lowest since 2018. However, mega-funds (those over $5 billion) thrived, securing over $445 billion, marking a 51% increase in commitments despite the overall downturn. Buyout funds, particularly larger ones, also posted gains, while smaller funds faced significant challenges. Deal-making activities declined by 24% in volume and 30% in value, impacted by rising borrowing costs and a more conservative approach from lending institutions. Despite this, middle-market and add-on deals remained strong, representing 56% of total deal count.

1. Investor Pressure and Changes in Terms:

1. LPs have pushed for more favorable terms, particularly in large funds, leading to reductions in management fees and increased focus on performance-based compensation. For instance, funds now frequently switch from a management fee based on committed capital to one based on invested capital after the investment period, with fees dropping from 2% to as low as 1.50% for larger funds
2. Innovative fund structures such as continuation vehicles and NAV loans have emerged to help GPs maintain liquidity and delay exits in a high-cost environment. These tools allow GPs to manage cash flows while keeping LPs engaged, helping to address liquidity challenges.

1. Integration of Technology and ESG:

1. The use of Artificial Intelligence (AI) is becoming more prominent in private equity/venture capital, aiding in investment decisions and portfolio management. Funds like "New PE" leverage AI to optimize investment strategies and improve performance. Additionally, ESG (Environmental, Social, Governance) considerations have grown in importance, with funds increasingly integrating sustainability factors into their due diligence and value creation processes.

Performance and Resilience:

1. Despite the decline in fundraising and deal-making, private equity remains a strong asset class relative to public markets. The median size of buyout funds grew, reaching $1.2 billion in 2023, the highest in a decade. However, the competition for capital has intensified, with only $1 being closed for every $2.40 targeted. The sector continues to adjust to these market challenges, emphasizing value creation through operational efficiencies

Conclusion

Private equity and venture capital companies fund terms have evolved to reflect the new realities of the market, particularly in response to higher costs and reduced deal-making activity. The traditional 2 and 20 model is increasingly giving way to more nuanced and flexible structures, with LPs demanding greater alignment of interests. Larger funds have been able to adapt more readily, offering reduced management fees and introducing more performance-driven incentives. AI and ESG factors are also playing a crucial role in the next phase of private equity, as firms look for ways to create value and mitigate risks in a highly competitive landscape.

Recommendations

• For LPs: Continue advocating for more flexible fee structures that prioritize performance over size, particularly as deal-making becomes more selective in a high-cost environment.
• For GPs: Explore innovative financing tools like

o   continuation vehicles (These vehicles offer liquidity options to existing LPs while allowing interested investors to maintain exposure to promising assets) and

o   NAV loans (refers to private capital solutions offered primarily to private equity funds based on the net asset value (NAV) of their investment portfolios.) to manage liquidity and maximize returns, while integrating AI and ESG into investment strategies to remain competitive.

This case study reflects how private equity and venture capital firm is adapting to the significant macroeconomic challenges of 2023 and 2024, paving the way for a new era of fund terms and performance-driven compensation.