Introduction
Why would a sponsor stretch to win an auction in the last year of its investment period, then turn down a full price for one of its best companies and hold it two more years? Usually because of how the firm is paid. A private equity firm earns money in three ways: management fees that limited partners (LPs) pay on the capital they commit, carried interest, a share of profits paid only after LPs have their money back plus a preferred return, and fees charged to the portfolio companies themselves. Each has its own payer and trigger, so each pulls in its own direction: fees toward raising and deploying larger funds, carry toward realized gains above the hurdle, portfolio fees toward transactions.
How Private Equity Firms Make Money: Three Streams, Three Payers
A buyout fund is a partnership between its LPs and the general partner (GP), the sponsor entity that manages it. The mechanics, from fee step-downs to catch-up arithmetic, are worked through in the Private Capital Advisory guide's waterfall article.
| Stream | Who pays | Usual basis | When it arrives | What it rewards |
|---|---|---|---|---|
| Management fee | LPs, through capital calls | A percentage of commitments, then invested capital | Every quarter from the first close | Raising and deploying capital |
| Carried interest | LPs, out of fund profits | Usually 20% of profit after capital and an 8% preferred return | On realizations, mostly late in the fund | Realized gains above the hurdle |
| Portfolio-company fees | The companies the fund owns | Transaction, monitoring and director fees | At deals and through the hold | Transactions, now largely offset |
A public pension's files show them for one real fund. When Rhode Island's treasury staff recommended a commitment of up to $40 million to Nautic Partners XI, a middle-market buyout fund, the June 2024 staff memo set out the terms: a 2% management fee during the investment period and 2% of invested capital thereafter, offset by 100% of transaction fees other than closing and commitment fees, and 20% carry on a fund-wide basis with an 8% preferred return and a 100% GP catch-up.
- Carried Interest
The general partner's share of a private equity fund's profits, usually 20%, paid only after limited partners have received their contributed capital and, in most buyout funds, a compounding preferred return. Earned on realized gains, it is the stream that most shapes when a sponsor sells.
"How do private equity firms make money?" is a common interview question, and "two and twenty" recites the contract; the behavior each line produces is what matters when advising a sponsor. Carry is a share of deal profits, whose sources the value creation bridge breaks down.
Management Fees: Fund Size and the Pull to Deploy
The management fee pays for the firm's team, offices and sourcing whether or not the fund makes money. It grows with the fee base, and the base changes when the investment period ends.
Fee Income Scales With the Fund
The surest way to grow fee income is a larger successor fund. The Rhode Island memo lists Nautic's Fund VIII at $900 million; in October 2024 the firm announced that Fund XI had closed at its $4.5 billion hard cap, above a $3.75 billion target. At a headline 2%, that is about $90 million a year in the investment period before discounts, against about $18 million on Fund VIII's size. At listed managers the pull is stronger, because public shareholders value recurring fee-related earnings (FRE) above carry, one reason the largest sponsors have built credit, insurance and evergreen businesses beside their buyout funds.
Why Uncalled Capital Becomes a Problem
A fee on committed capital does not by itself require spending. The pull comes from the end of the investment period: in most buyout funds the fee then moves to invested capital, so capital never called stops earning, and the fund generally loses the right to buy new platforms. Growth waits on deployment too, because LPs expect a fund to be largely committed before its successor is raised, the handover traced in the fund lifecycle from the coverage seat.
After the investment period the incentive reverses, because each exit that returns cost shrinks the invested-capital base. A fee-only reading would favor holding longer; carry and the distributions the next fundraise needs usually override it, the tension examined in dry powder and distributions to paid-in capital (DPI).
Carry and the Hurdle: What Decides When a Sponsor Sells
Carry's terms set how a sponsor weighs a price today against a higher one later.
The Hurdle Counts Years, the Carry Counts Dollars
The preferred return compounds, usually at 8% a year, on capital still outstanding, so the hurdle rises every year an asset is held. Once a fund is past it and fully caught up, the GP's carry is simply 20% of total profit, and a dollar earned in year six adds as much carry as one earned in year four. LPs judge the same deal on internal rate of return (IRR) and cash returned, both of which reward speed.
The calculation flips near the hurdle. A fund below it sees the preferred return grow each year, and a fund inside a full catch-up passes each extra dollar of proceeds to the GP until it holds its 20%, so a sponsor in either zone cares about price and speed at once. Fund age, realized multiple and marks give a reasonable estimate of the zone before an exit pitch.
Whole-Fund vs Deal-by-Deal Carry
Where carry is measured changes the urge to sell winners. Under a whole-fund waterfall, Nautic XI's structure, selling a strong company early mostly returns LP capital, and carry waits until the whole fund clears its hurdle. Under a deal-by-deal waterfall, selling a winner can pay carry at once, subject to escrow and a clawback if later deals disappoint. Cambridge Associates' review of fund terms found deal-by-deal structures in 22% of the funds it examined for 2022, across all strategies, and most often in buyout and real estate; samples and counts differ by survey. A GP on those terms has more reason to sell its best assets first; the protections are compared in European vs American waterfalls.
Selling an asset into a continuation vehicle (CV) the same GP manages is also a realization for the old fund, so carry can crystallize at the transfer price. The Institutional Limited Partners Association (ILPA) asks that in almost all cases the GP roll all of it into the new vehicle, as CV economics explains.
Portfolio-Company Fees and Who Pays the Bank
Sponsors have long charged transaction fees for arranging acquisitions and financings, periodic fees under monitoring agreements, and director fees for board seats.
Transaction and Monitoring Fees, Mostly Offset
Because the company pays these fees out of value that belongs to the fund, LPs negotiated fee offsets. In KKR's 2006 flagship fund, according to a 2015 Securities and Exchange Commission (SEC) order, the management fee was reduced by 80% of the fund's share of monitoring, transaction and break-up fees. By 2022 the Cambridge Associates review found 93% of all funds offsetting 100% of transaction fees; every buyout fund in the sample had an offset, 9% of them below 100%.
- Monitoring Fee
A periodic fee a portfolio company pays its private equity owner under a monitoring or management services agreement, nominally for advice and oversight during the hold. Most fund agreements offset it against the management fee, and some let the remaining years be paid in a lump sum on a sale or listing.
That lump sum drew enforcement. In August 2016, four Apollo-affiliated advisers agreed to a $52.7 million SEC settlement that included inadequate disclosure of their practice of collecting accelerated monitoring fees on a sale or listing, payments the SEC said reduced the companies' value. The SEC's later quarterly fee statement rules were vacated by the Fifth Circuit in June 2024, as the article on the private fund adviser rules and their vacatur explains.
Who Pays the Bank on a Buyout
The same logic answers whose money pays the bank. On a completed buyout, advisory and financing fees are generally paid at closing out of the debt and equity raised, so the company bears them; the KKR order describes the sponsor being reimbursed directly by portfolio companies for expenses on successful transactions. A dead deal is different. Its broken-deal expenses, which the order lists as research, travel, professional fees and similar costs, fall largely on the fund. KKR, which incurred about $338 million of them from 2006 to 2011, paid nearly $30 million to settle charges that for years it allocated none to co-investors who shared in its deals, a reminder that co-investment syndication splits costs as well as returns.
When Fees, Carry and Distributions Point the Same Way
The streams line up fully in one situation: a strong company in a fund past its hurdle while the firm raises its next fund. Carry is in the money, realized gains help the fundraise, and the shrinking fee base costs little, so the sponsor wants a sale, soon.
Elsewhere they pull apart, and many requests between entry and exit are attempts to reconcile them. A dividend recapitalization returns cash to LPs while keeping the upside that drives carry; a continuation vehicle realizes value for the old fund while the sponsor keeps the asset; a stretch bid finishes deploying a fund whose fee base is about to shrink. Knowing which stream binds a given fund turns a sponsor's request into something a banker could have anticipated.
