Acme Investment Trust Executive

Overview Acme has recently raised the private equity allocation of its $10 billion pension fund from 3% to 6% and is considering partnerships with 2 new private equity funds, namely Warburg Pincus (WP) and Hummer Winblad (HW). However, both funds have announced changes to the fee structures that they have used in the past, changes that ignore what is typical in the industry and provide conflicting messages for the future’s outlook. Before investing, Acme would like to gain a better understanding of what these changes indicate, whether management’s incentives are still appropriately aligned and whether it is still a good idea to invest in either of these funds.

Compensation Structure The standard for general partner compensation in a private equity firm is a 2% management fee that helps to cover ongoing operations and a 20% allocation of profits. The fact that 81% of venture capital funds follow this same compensation structure is a testament to the consistently high growth expectations of these types of funds. However, deviation from this standard in the form of increased management fees (from 1% to 1.5%) and reduced carry (from 20% to 15%), as is the case with WP, may be interpreted as a gloomy growth outlook. Acme pension managers provided some validity to this idea, suggesting that increased flow into private equity from institutional investors would lead to lower returns, thus making carry a less attractive option for securing profit.

Financial Analysis From a financial perspective, the changes to WP’s structure actually increase compensation during periods of low growth. For example, if the growth rate over the next 12 years (the duration of the fund) is 5%, the NPV of compensation increases from $92 million under the old structure (Exhibit 1) to $120 million under the new structure (Exhibit 2). However, if the growth rate increases to 20% or 35%, which is more typical of WP’s past funds, the NPV of compensation