Chapter 3 Part 2: How PE Funds Actually Work - Fees, Incentives and Power
So you have a bunch of big investors who want to put money into private equity but don’t want to pick companies themselves. What do they do? They hand their money to a fund manager and say “go make us rich.” Sounds simple. But the details of how that relationship works, how the fund manager gets paid, and what stops them from just enriching themselves at your expense? That is where it gets interesting.
This is section 3.2 of Demaria’s book, and honestly, it is one of the most practical parts of the entire thing. Let’s break it down.
Fund Managers: The Middlemen
A typical PE fund lasts about 10 years. The first 5 years are for investing the money, and the second 5 years are for selling those investments and returning cash to investors. Some funds go longer. Infrastructure funds can run 15 years. Funds of funds stretch to 13. And venture capital funds with “zombie” companies that never really worked out? Those can quietly drag on for 15 or 20 years.
The fund itself does not have a legal personality. It does not pay taxes. The money flows through it to the investors, who then deal with taxes on their own. The fund manager is the entity that actually exists legally. They are the permanent team. The fund is just a temporary vehicle.
To show they have skin in the game, fund managers are supposed to invest at least 1% of the fund’s total size. Currently the average is above 3%, according to Preqin. But here is the thing Demaria points out: a 1% contribution can be earned back in 6 to 9 months just from management fees. Even 3% gets recouped in 9 to 24 months. So “skin in the game” is not as deep as it sounds.
Once the fund has its final closing (no more new investors coming in), the fund manager goes to work. They find deals, negotiate terms, call the capital from investors when it is time to buy something, monitor the investments, and eventually sell them. Then they distribute the proceeds. That is the job.
How Fund Managers Get Paid
This is the part everyone cares about.
Management fees are the base salary of the fund. Usually 1.25% to 2.5% per year for a direct fund (0.5% to 1% for a fund of funds). During the investment period, this is calculated on the total fund size. After that, it switches to the net asset value of the portfolio. On top of that, there are setup costs (around 1% of the fund), administrator fees, audit costs, legal fees, and due diligence expenses. If a deal falls through, those expenses are still gone. The industry calls them “abort fees.”
Then there is the big one: carried interest. This is the performance fee. Generally 20% of the profits (5-10% for funds of funds). The idea is simple. If the fund makes money, the manager takes a cut. This is what is supposed to keep them motivated.
Some managers have started using tiered carry. For example: if the fund returns less than 10% IRR, the carry is 0%. Between 13% and 17% IRR, it is 15%. Above 25% IRR, it jumps to 30%. Smart on paper, but Demaria notes the IRR metric itself has problems, which he covers later.
The hurdle rate adds another layer. Before the fund manager gets any carried interest, the fund has to return all the invested capital plus a preferred return to investors, usually 6% to 8%. Only after that threshold is cleared does the manager start collecting carry. There is also a “catch-up” clause where the manager gets a portion to make up for the hurdle period.
European vs. American Waterfall
How profits get distributed follows one of two models.
The European waterfall (used by 80%+ of funds worldwide) says: the fund manager does not see a penny of carry until the entire fund has been repaid to investors and the hurdle rate has been met. At the fund level. This is conservative. The manager might wait 6+ years before seeing any carry. But when it comes, it is final.
The American waterfall works deal by deal. If one investment is sold at a profit, the manager can collect carry right away, as long as the capital for that specific deal is repaid and the hurdle is cleared. The upside for managers is they get paid sooner. The downside? If the next deal loses money, they have to give the carry back. That is the “clawback” clause. Only the top-performing managers can get away with this structure.
Conflicts of Interest (There Are Many)
This is where Demaria gets really useful. He lays out the ways fund managers can act against their investors’ interests.
Fee double-dipping. Fund managers sometimes charge fees to the portfolio companies they manage on top of the management fee from the fund. In Europe, most fund agreements require these fees to be offset against management fees. In the US, the SEC has been cracking down since 2015.
Playing favorites between funds. When a manager runs multiple funds at the same time, which fund gets the best deal? The old one that is nearly done? Or the new one that needs early wins? Fund rules can set up priority or pro-rata allocation, but the temptation is real.
Zombie company holding. A company that is going nowhere can be kept in the portfolio just to keep the NAV up and management fees flowing. Nobody is incentivized to pull the plug when fees are tied to portfolio value.
Inflated valuations. The fund manager is the one reporting how much the portfolio is worth. Auditors certify the method, not the result. That is a big difference. A generous valuation makes the fund look good for raising the next fund and keeps management fees high.
Information control. Investors only know what the fund manager tells them. Quarterly reports and annual meetings. That is basically it. Some fund managers even keep their investor lists secret, which makes it harder for investors to organize and push back.
The FOIA situation. When the San Jose Mercury News pushed public pension funds like CalPERS to disclose their PE fund performance, some fund managers responded by… refusing to accept public pension fund money. They would rather have fewer investors than risk transparency. That tells you something.
Power, Checks and Balances
Investors are not completely helpless. But their options are limited.
The Limited Partnership Advisory Committee (LPAC) is a board where select investors advise on conflicts of interest. But the seats are limited and the role is advisory, not executive. They can flag problems but not necessarily fix them.
The key person clause ties the fund to specific managers. If the people you trusted with your money leave, the fund may have to pause or shut down. This is one of the most powerful protections investors have.
The no-fault divorce clause lets investors fire the fund manager even without specific misconduct. You just need a qualified majority vote, sometimes a unanimous one. But in practice, replacing a fund manager is messy, expensive, and rare. The new manager needs to be found, motivated, and brought up to speed on an existing portfolio.
The real power investors have is the threat of not re-upping. When a fund manager comes around to raise the next fund, the decision of whether or not to invest again is the strongest form of feedback. Lawsuits are almost unheard of in this world. They destroy relationships that are supposed to last decades. So the silent sanction of walking away is how things actually work.
Demaria is honest about the power imbalance here. Fund managers still largely call the shots. But the growing professionalism on both sides, combined with regulatory pressure, is slowly pushing toward better standards. Slowly.
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