Wednesday, June 27, 2007

Private Equity Like S&Ls?

I'm sure I'm not the first person to note this, but it seems to me the

The funds typically get 20% of profits in an up year, in addition to a (relatively) small "keep the lights on" management fee. In a down year, they collect the managmenet fee, but if there are no profits, they get no returns. However, I don't think there is typically a "carry forward of the losses". So in the world of private equity management, it is better to go 30, -40, 25 (average return to investors of roughly 5%, but fees of 11%), than to go 10, 10, 10 (average return to investors of 10% but fees of 6%). It's a bit like bookmaking, where the tie goes to the house.

So the motivation is to have some REALLY BIG years, even if that also means having some REALLY BAD years. It reminds me a bit of the pattern for the federally insured S&Ls that crashed 2 decades ago. If your worst-case is to lose nothing (because your government-sponsored insurance will cover any losses), then you almost, almost have a fiduciary responsibility to your investors to take huge risks, if they have a greater expected return than safer alternatives (and it is axiomatic that they should).

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