Why can you make so much money in private equity as an investor?

Let's look at both sides of the transaction. Investment bankers make money by advising companies, structuring sales, raising capital, and taking a percentage fee on each transaction.

By contrast, private equity firms make money by exiting their investments. They try to sell the companies at a much higher price than what they paid for them. The profits are then divided up based on a distribution waterfall. The amount paid to the GP is generally referred to as carried interest, or carry, and is typically around 20% of the profit made on a fund exit.

The GP also collects management fees, typically around 1.5-2.0% of committed capital during the investment period when new investments are allowed (usually the first 5 years). They charge this management fee to pay salaries and "keep the lights on," that is, to cover the core operating costs of the fund before and between investments, since profits in PE are very lumpy — there can be years of no profit and then suddenly tons of profit come raining down in a single year when multiple companies are exited.

Management fees alone represent a pretty significant chunk of cash over the life of a fund. And they are not based on performance! If a fund has a 10 year life, you can do the math. For even a paltry $50M fund, a 2% annual management fee means $1M per year for at least 5 years, regardless of performance, no matter how few investment professionals there are (there might only be one or two!). A $1B private equity fund would draw $20M per year in management fees alone, a handsome sum especially if you have a small investment team.

That's why PE firms pay such high salaries to associates and investment staff. Mega funds may have many billions under management leaving hundreds of millions just for employee compensation. Since running a PE fund isn't exactly a capital intensive business (you only need some laptops, phones, and desks), employees end up getting paid a lot. In terms of headcount, even the largest mega cap funds may only have 150 investment professionals. Small firms might just have a dozen or even a few.

Average compensation per employee from management fees alone could easily top $1 million annually, although senior professionals would always earn more than junior staff.

Be sure to check out our PDF guide "How to Nail Your Private Equity Interview (whether you have finance training or not)" for in-depth tips and strategies on how to successfully interview for jobs at top private equity firms!

Also be sure to check out our step-by-stepPrivate Equity LBO Modeling Training Videos for walk-through tutorials on how to build an LBO model, navigate Excel with ruthless efficiency, and rapidly create an LBO PowerPoint deck to present to your PE interviewers.

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