There is a subtle but insidious trend burgeoning within France’s private equity industry. This trend is a shift in fund objectives from a “capital gains generation” model towards a “fee generation” model.

In other words, the financial benefits accruing to private equity GP’s are increasingly coming more from management fees than from carried interest.

As many of you may know, venture capital and private equity general partnerships extract value from the investors of the money they manage in two ways: fees and carried interest. Historically, a conventional LP/GP agreement would have a “2 & 20” structure, meaning that the GP assessed an annual fee of 2% on the amount of money they manage, while sharing in 20% of the funds’ capital gains in the form of carried interest. The conventional wisdom held that the 2% management fee was sufficient to cover the operating expenses of a fund (i.e. office rent, staff salaries, legal expenses, conferences, etc.), while the 20% carried interest was intended to reward supersize performance of the fund managers once they’ve returned all of the investors’ money.

So for example, a general partnership managing a fund of 100m in size and returning 3x the investors’ money at the end of the life of the fund commitment would receive:

• 2m per year in management fees
• 40m in carried interest (20% of fund gains of 200m)

Whereas an underperforming general partnership that fails to return all of the investors’ money (usually + some minimum “hurdle” rate of return) will not receive anything in the form of carried interest.

This “2 & 20” model, with slight variations across general partnerships, has generally worked well for the past several decades in the sense that both LP’s and GP’s found their respective returns and incentives to be properly balanced.

This model merits scrutiny, however, when fund size becomes disproportionately large. An annual management fee of 2% of 100m sounds appropriate, but the same fee percentage on a fund size of 1 billion would be 20m per year. Because administering a fund of 1 billion doesn’t require a significantly larger management structure than for a 100m fund, 20m a year seems like an awful lot of money just to keep the lights on.

Concerns over this model surfaced in the U.S. some years ago, before the private equity bubble burst, when many buyout funds were becoming multi-billion dollar behemoths. The subsequent credit crunch and ensuing defaults or drastic reductions in commitments to the asset class from LPs served to correct many of these imbalances.

I fear however, that in France these imbalances, while also currently masked to some extent by the credit crunch, are threatening to grow unchecked.

Wouldn’t France’s private equity industry follow a similar course correction on this matter as its anglo-saxon counterpart ? Three primary distinctions suggest otherwise:

1. Investors in French private equity and venture capital funds encompass much more than than institutional LPs. While the classic LP/GP fund still exists, it is being forced to make room for retail investment vehicles. Increasingly, tax-incentivized retail investors represent significant sources of funds for the asset class. In 2009 for example, retail investors represented a whopping 1.1 B€ of the 3.6 B€ in total fundraising. Retail investors, (“unsophisticated investors”, to borrow the U.S. term) are as a class empirically less discerning and demanding than institutional LPs.
2. Tax incentives skew the retail investors’ motivations. Retail investment vehicles are booming thanks to generous tax incentive mechanisms. For example, an investment in a typical FCPI or FIP vehicle allows a 25% instant tax credit on one’s income tax and up to a 50% instant tax credit on one’s wealth tax. Then there are the incubator holding vehicles which can offer a wealth tax credit of as much as 75% of the invested amount. Retail investors’ expectations of capital gains are overshadowed by the immediate gratification they receive in the form of a tax shield.
3. Egos abound in both cultures, but manifest themselves differently. The pride factor in anglo-saxon private equity and VC culture centers on capital gains (e.g. every VC dreams to find the next Google); whereas France’s industry professionals tend to favor the amount of assets under management as a measure of testerone.

The first two distinctions might explain the dramatic disparity between returns of institutional funds and retail funds. For example, a comparison of IRRs for French private equity funds since inception through year-end 2008 depicts a 26.8% IRR for the top quartile of institutional funds versus a paltry 1.9% IRR for the top quartile of retail funds (see graphs. FCPRs are institutional fund vehicles, while FCPIs and FIPs are the tax-incentivized retail investment vehicles).

The damage of these characteristics of France’s private equity industry is compounded by the steadily ratcheting up of management fees: while 2% used to be an industry standard, fees in the 3~4% range are rapidly becoming the norm in France.

So wherein lies the “break-even point” ? i.e. how large can the pool of assets under management be without tipping the motivations of the GP’s away from capital gains generators to fee generators ? My fear is that this threshold is not that high.