Sachin Khajuria - Two and Twenty: How the Masters of Private Equity Always Win

Two percent in annual fees. Twenty percent of the profits. These are the fees private equity firms charge investors to manage and invest their money. The firms earn fees for running the cash they are entrusted with, and they also earn a share of the resulting profits from investments. This Two and Twenty formula sits at the core of the private equity industry, and although there are variations of it across firms and funds, it is the industry benchmark. Its an incentive that has helped create tremendous wealth for these dealmakers, while aligning the objectives of those who take the risk to put up the capital and those who seek to make profits from it on their behalf. In the simplest terms, the more money the investors make, the more the professionals make. They can both win together.

Today, private equityin combination with other forms of private capitalis a $12 trillion industry. It doubled in size during the 2010s, and by the end of this decade, it could well exceed $20 trillion. At the most basic level, what private equity does is invest money into an operating enterprise, a real business (or business plan) that needs to be fixed or that requires capital to grow, and then improve it before exiting at a profit. Put like that, it sounds simple. Private equity professionals pierce the veil, going beyond merely weighing the pros and cons of trading securities to understanding the workings of the underlying enterprise itself, just like a good company CEO would. Moreover, through the size of their investments, typically a controlling stake, private equity firms act like engaged owners, not passive investors. They eat what they cook. And that makes all the difference.

We cannot overestimate the reach of private equity across the global economy at this point. It is present nearly everywhere, in sectors as diverse as chemicals, energy and power, banks and insurance, consumer and retail, aerospace and government, manufacturing and industrials, media and telecommunications, leisure and entertainment, healthcare and pharmaceuticals, and technology. It has invested in subsectors we might not think of as natural habitats for Wall Street, from our childrens schools to food storage to dating applications to family-ancestry tracing to military and intelligence technology. The vehicles used to make these investments are dizzying in their variety, from the traditional private equity funds that raise capital once and draw down commitments as required, to publicly listed funds, to the burgeoning class of funds that keep going without a finite life (so-called permanent or perpetual capital), to special-purpose vehicles funded on a one-off basis by pension funds and other investors or the balance sheets of private equity firms. There are hundreds of established private equity firms and hundreds more newer ones behind them. New firms crop up every year or two. At the apex of the industry sit a dozen major firms, the biggest of which are publicly listed, such as Blackstone and its rivals Carlyle and KKR. Its all too easy to get lost in the maze.

Blackstone manages over $875 billion in assets across investment strategies. Some firms are open about their desire to manage over a trillion dollars in assets themselves within just a few years. Taken together, the largest publicly listed firms manage over $2.5 trillion in assets. And even though the size of funds under management seems enormous, it underestimates the purchasing power of each firm, because of the multiplier effect of leverage. Money that is put to work in private equity funds can be leveraged by the debt raised on top of it to make investments. The unspent money in private equity funds, dry powder as we call it, can be multiplied by adding debt on top when investments are made. Take a relatively small fund, totaling $1 billion, and add $3 billion of debt. You now have $4 billion of purchasing power. Now consider not just private equity but all forms of private capital managed by private equity firms that can have debt raised on top of the money invested from the funds. Thats trillions of dollars to invest.

Within our childrens lifetimes, the industry could well be managing tens of trillions of dollars in assets. The field is huge and lucrative and has its fingers in nearly every sector of the economy, and yet the average person scarcely thinks about itor would be able to explain how the industry works. Consider this: When we talk about private equity capital, we are, to a substantial extent, referring to money that belongs to the retirees of tomorrow. We are talking about individuals who relyvia their pension fund managerson an industry they probably dont understand very well to deliver the returns they will need to live off in old age. We are talking about tens of millions of workersemployees like teachers, firefighters, and other pensioners around the world.

The rise of private equity has been hiding in plain sight. The industry doesnt mint the kind of high-publicity executives you find in big tech companies like Amazon or Tesla or Apple. But its reach is staggering. Investors turn to private equity to deliver higher, more consistent returns that are hard to get elsewhere. And as private equity firms introduce other strategies, such as credit, real estate, and infrastructure, these investors allocate money to those strategies too. The largest firms have become one-stop shops for alternative investments. Yet few outside Wall Street think much about them.