In negotiating private equity fund structures, determining the structure and size of the management fee – including which expenses this fee should cover – are clearly sensitive issues for both GPs and LPs. Of the many terms in a partnership agreement to negotiate, travel fees do not loom largest. But mundane as they would seem, travel fees are, in fact, negotiated by LPs who argue that they should not be charged for expenses that should be covered by deal fees or the management fee.
LPs want to make sure that the management fee is indeed being used for its intended purpose – which many LPs view as including travel needs – and do not like to see themselves being charged more than once for such expenses.
Travel expenses are “definitely a negotiated item, says Thad Gray, a managing director at New York fund of funds manager Abbott Capital. There are various ways to account for travel expenses within the LP agreement and the management fee structure, and Gray notes that there exists no standard of how to treat travel expenses – whether paid by the management fee, deal fees, the partnership, the partnership and then reimbursed by deal fees, or some combination of the aforementioned.
Charles van Horne, another partner at Abbott Capital, describes the compulsion on the part of GPs to charge the partnership for travel expenses as “investment-bankeritis. If you've been inside an investment banking operation, you learn how to charge for as many things as you can, van Horne says.
Indeed, some types of expenditures are more likely to offend LPs than others. For example, Abbott Capital pushes back particularly hard when GPs attempt to charge the partnership for travel unrelated to specific deals, such as travel to industry conferences. “That should come out of the management fee, says Gray.
In addition to being a sensitive issue between GPs and LPs, travel expenses can also create tension between GPs within the same management company. One industry observer describes a firm where a managing partner flies by private jet when travelling on business. To avoid internal strife over costs, the partner charges the management company only for the cost of a first-class ticket on a regular airline, then pays for the difference personally.
In the US, whether the GP or LP is responsible for travel expenses “tends to vary across the quality of fund organizations – the GP will tend to have more leverage if its fund is oversubscribed, and less leverage if it is facing a competitive fund raising environment, says Kenneth Muller, the San Francisco-based co-chair of the private equity group at Morrison & Foerster, the law firm. Muller, who handles fund formation and is an advisory board member of “Private Equity Partnership Terms & Conditions,” a survey published by Dow Jones' Private Equity Analyst, cites the published results from this year's survey, which shows that out of approximately 100 US-based GPs, over 60 percent of buyout firms bear the travelling expenses of the funds they manage. Meanwhile, roughly 80 percent of venture capital GPs bear these costs.
These results contrast with the experience of a number of industry sources, who say they rarely see cases where travel expenses from the operation of a fund will be charged back to the LP. “In our experience, travel expenses are included in the management fee without exception – you never see them reimbursed separately, says investment advisor Alignment Capital Group's Craig Nickels, based in Austin, Texas. “Broken deal expenses can sometimes be charged to the fund, but these are typically considered extraordinary expenses.”
Mike Kelly, a managing director at investment manager Hamilton Lane, agrees: “The management fee covers operating costs – we pay them a fee, they do what they want with it, and in the waterfall they have to pay back the fees, like a loan.”
Some groups, such as Ireland-based venture capital investor Delta Partners, set clearly defined terms in the partnership agreement. “We receive a management fee based on the amount of capital under management, and that fee needs to cover nearly all expenses, which definitely include travel expenses, says John O'Sullivan of Delta. “This is a typical set up with an LP, and it is difficult to imagine how it would be done a different way. The LPs don't want to have to pay twice.”
Other LP agreements do not clearly define what can or cannot be expensed to investors, but leave the decisions up to the GP's discretion. “We don't actually have a formal policy on this, but we do have a well established practice, says Paul Cunningham of UK-headquartered Barclays Private Equity. “Any travel expenses incurred in doing deals or monitoring investments, we tend to bear ourselves, and then offset that against income from the management fee or the portion of the monitoring fees that we retain. We have the ability to charge certain travel expenses back to the funds, but on the whole, we don't.”
However, the assignment of travel expenses continues to evolve and may swing toward the other end of the spectrum depending on market conditions. “Each time we come under more pressure from investors to allow them to keep their entire portion of the transaction fees and the monitoring fees, says Cunningham. “If that were ever to happen, then we would have to look to see if we should charge any specific fees back to the LPs.”
While there is a wide range of practices for treating travel expenses, both GPs and LPs should be aware that what works for one partnership may not fit well for another. It is safe to conclude only that how a partnership integrates travel expenses into a fund's cost structure is an important consideration and should be geared toward the nature of the fund.