How funds are structured: The one who manages, those who pay

Behind the buyouts and the start-ups, there are funds. And almost all of them share the same architecture.

On one side, the general partner. That is the management company: it chooses, buys, sells. It decides everything.

On the other, the limited partners. Pension funds, insurers, large fortunes. They bring almost all the money.

But they decide nothing day to day. Their risk is limited to what they promised. So is their power.

How is the manager paid? The classic formula fits in two numbers: two and twenty.

Two per cent in management fees a year. Whether the fund gains or loses.

And twenty per cent of the profits, often above a minimum return. This share is called carried interest.

Say a fund of one hundred million euros over ten years. Two per cent a year: twenty million in fees in total.

That leaves eighty million to invest. Say it becomes two hundred and fifty. More than three times the stake.

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The profit: two hundred and fifty, minus the one hundred million put in. One hundred and fifty. The manager keeps twenty per cent: thirty million.

Investors get two hundred and twenty million back for one hundred. Two point two times the stake. The manager has collected fifty million.

The investments made more than three times the stake. The investors, a little over two. The difference is the structure.

Second feature of these funds: they lose first. That is the J-curve.

In the early years, you pay fees, you buy, and nothing has been sold yet. The counter is in the red.

Then the sales come, often after five years or more. The curve rises again. If all goes well.

Judging such a fund after two years is judging a tree by its seed.

Last feature: the capital call. When you sign up for one hundred million, you do not pay one hundred million.

You promise. The manager calls the money as it goes, when it finds a company to buy.

So you must keep this money available, sometimes for years. And answer every call, or the penalties are heavy.

This money promised but not yet called has a name: dry powder.

Three things to remember. The manager decides, the investors pay. And fees fall even when everything goes wrong.

Finally, the return comes late. In this business, patience is not a virtue. It is a clause in the contract.