Charged up over management fees

The historic two-and-20 fee model is belied by a host of idiosyncrasies and the headline fee charged only tells you so much.

Despite dramatic increases in fund size, management fees remain stubbornly close to historic 2 percent norms, probably averaging at closer to 1.75 percent today. But as the scope and scale of private equity operations has increased, so too has the complexity of management fee calculations. The headline fee charged only tells you so much.

First up is the question of when the management fee begins to be charged. Historically, this has tended to be when a first close is reached, true of 54 percent of respondents to (then-named) Private Funds Management Fees & Expenses Survey in 2016 and 51 percent two years later. But there has been a marked shift in the 2020 findings, with just 24 percent starting the clock at first close. By contrast, the management fee is far more likely to be charged now at the point of the first capital call, or even some stated time after the first investment has been made.

“I’m not surprised,” says Saw Mill Capital CFO Blinn Cirella. “Just because a fund has held a first close, doesn’t mean it is investing. Management fees are cash out of the LP’s pocket and they don’t want to pay the fund until they are actually making investments.”

There has also been a step up in the proportion of managers kickstarting fees when the rate of the predecessor fund steps down. PEF Services CEO Anne Anquillare believes this is a logical approach to the contentious issue of bridging between two funds.

“Investors don’t want to pay for the same thing twice. You are not getting two management companies,” she says. “There has to be some sensitivity about how to wind down management fees in old funds and there definitely needs to be transparency during that transition period. Tying the start of the new management fee in with a step down in the old management fee makes a lot of sense. There needs to be co-ordination.”

Troutman Pepper partner Julia Corelli, however, finds this development surprising. “Only the biggest funds would not find this consequential to the management team. If it is happening in the mid-market, it must be as a result of lots of pressure from LPs,” she says.

Another challenge associated with transitioning between an existing fund and its successor involves the extent to which the manager is prepared to offer preferential economics. The GP will want to entice incumbents to re-up, while balancing that against the need to diversify its investor pool. Striking a fair and strategic approach to inducement is therefore key.

Offering preferential rates to those prepared to come into the fund early remains the most prevalent tactic, used by a third of GPs. A further 16 percent are prepared to offer preferential rates on the new fund to re-uppers, while 12 percent approach the issue from the other direction, offering re-uppers adjustments on rates in the previous vehicle. “We definitely see economics offered to investors coming in as anchors, but it is important to be careful,” says Anquillare. “You never want to give away economics in a future fund because you don’t if you will still want that anchor. And you don’t want to scare off other investors. It’s a delicate balance.”

“Early closer or re-up discounts are driven principally by demand,” adds Cirella. “For newer funds, or funds that typically take longer to hold a final close, LPs do not have the same sense of urgency and may find it economically disadvantageous to be an early closer. Particularly since the economic crisis, newer funds and certain funds of funds may offer one, or both, of early closer discounts and re-up discounts. For over subscribed funds holding a final close in a relatively short period of time, these discounts are less frequent.”