This article is sponsored by Withum
What do you currently see as the hot talking points for managers and LPs when it comes to fees and expenses, and have any of those been impacted by the pandemic?
Reflecting back to when all funds with regulatory AUM over 150 million had to register upon the passage of Dodd-Frank, we saw the creation of the asset management division of the SEC. They began looking at typical fee and expense relationships. Some of the items they noticed early on led to enforcement action against several firms.
A lot of items were brought to light that LPs didn’t realize, because GPs until then had a lot of discretion. The LPs were focused on returns and not particularly focused on expenses. However, once the enforcement actions were publicized, we saw more transparency. The LPs started to pay attention to the items they were getting charged to the fund. Things that were highlighted included monitoring fees, finance fees and closing fees.
The number of firms charging those fees has reduced over time. Many firms started to charge management fee offsets, reducing the cost passing through to LPs. The management fee itself hasn’t really changed, but there are more items offsetting the management fees.
In terms of the pandemic, we have not seen any changes on the structure of arrangements; fundraising has pretty much come back and with the stock markets back as well, there is plenty of capital and nothing affecting fees and expenses.
What are the latest developments on management fees in particular, both when they are charged and how they are calculated?
Before Dodd-Frank, it was standard practice to charge management fees from the first closing but since then, because of the SEC heightened focus on fees and expenses, most now charge them from the first capital call.
Another change, because of the transparency that has come to the market, is that if a manager launches a successor fund they won’t charge fees in the new fund until they start to step down the rate in the first fund.
“Many expenses that have received a lot of attention through enforcement, and growing LP awareness, are now in the spotlight”
There are two ways we see this occurring in the market; some managers will charge the same rate but it is on invested rather than committed capital, so in essence the fees have come down. The alternative is to charge the rate on commitments but reduce the rate charged on commitments.
In both cases, managers are lowering the rate they are charging in the original fund. That is where we see the real movement at the moment, around successor funds.
With fund extensions and restructurings becoming an increasingly common feature, do you see LPAs evolving to stipulate what will happen to fees and expenses in those circumstances? What provisions should be made?
There is a definition around management fees charged during fund extension periods in the agreements, with about 70 percent of agreements including a defined rate for those extension periods. Once the funds go past the stipulated extension period, then 70 percent of the funds we surveyed in the Fees & Expenses Survey 2020 are negotiating those fees at the time of the extension. That is always problematic because you are trying to negotiate the extension and the fee for that extension simultaneously.
A lot of the fund agreements drafted a decade ago didn’t anticipate running past the extension periods, so there was no thought that they should include language to address what would happen in that circumstance.
Since exceeding the extension periods has become more widespread, attorneys tell me they are adding wording clarifying the fee structure past the extension period. What the agreements actually say varies; there is always a fee reduction, but it may be 50 percent or more. We talked to some LPs and attorneys who don’t want to make that fee zero because they want to give some incentive for the manager to continue to work the assets. But it is always reduced.
There is also a lack of clarity on restructurings that may occur. For example, GPs may want to restructure the fund by rolling investments into a new fund, bringing in new LPs and current LPs rolling over but there is no discussion in the agreement on who pays the fees on the restructuring at the end of the fund life.
That is another event that wasn’t contemplated and is now being put into current documentation. Now LPs are aware of these situations; they can go back and check their documents to see what they say. If they are silent, it is probably a good time to negotiate with the GP before the situation arises. That is also good for the GP, allowing them to know in advance who is on board and what the cost structure might be.
Where do managers currently face the most pressure from investors when it comes to expenses? Do you think managers are consistently deciding against charging expenses to the fund that are expressly permitted in the LPA or PPM? If so, why?
Many expenses that have received a lot of attention through enforcement, and growing LP awareness, are now in the spotlight. For instance, phase one of the enforcement was focused on operating partners: firms had operating partners listed on their website, it appeared they worked for the firm and were paid by the firm, but it turned out they were being paid by portfolio companies. That in turn reduces the profitability of the company and therefore reduces the value of any potential sale. Expenses for broken deals is another example. LPs would rather not pay those costs, and that’s why we have seen an increase in the management fee offset.
“There are a lot of items up for discussion and disagreement”
In the Fees & Expenses Survey 2016, broken deal fees were charged to the fund by over 80 percent the funds surveyed, and yet by 2020 that had decreased to under 70 percent. Obviously, pressure is being applied by the LPs, who are aware and now pushing that issue.
A number of these expenses were not defined in the LPA, but we are now seeing a lot more detail in the agreements about what’s allowed to be charged to the fund and what isn’t. The documents have a lot more detail around fees and expenses. Most older documents listed a few expenses but left a lot of latitude to GP discretion. The trend to more detail will continue.
Another interesting fact is that the latest survey showed 40 percent of LPs would not charge the fund for an expense that’s permitted in the LPA. So they may think it’s grey even though it’s allowed and figure it’s not worth charging through and having an issue with the LP or the SEC. My guess is that if it’s specifically allowed then the SEC wouldn’t have a problem, but perhaps there is a need for some tightening of the drafting of the LPA to avoid any misinterpretation.
Finally, what other LPA terms do you see causing the most disagreement with GPs during fund due diligence, and what new issues do you see on the horizon going forward?
There are a lot of items up for discussion and disagreement. One survey question I thought was interesting was, despite everybody wanting co-investments – which LPs like because they reduce the cost of capital and GPs like because they can access larger deals and potentially get to know new investors – the SEC concerns about cherry-picking LPs to participate in co-investments appears to have made GPs wary of having to include all LPs.
In 2018, 87 percent of firms had co-investments, yet by 2020, that had dropped to 75 percent. I can only conclude that since GPs now have to offer those opportunities to all LPs equally, some managers might have decided It is logistically difficult to get responses back from all LPs in a timely manner. Therefore, they decided not to offer them.
I don’t think co-investments will go away because they are so important to most LPs, so if you have an anchor investor who wants them, you will offer them.
The other evolving situation is the LP Advisory Committee, which was originally designed to have some key LPs in a monitoring role. It has grown into more of an independent director position, where the GP request committee sign-off on important matters. LPs are reluctant to join on that basis for fear of becoming responsible for those issues. They don’t like signing off on valuations, for example, and they often worry about conflicts because they are meant to be representing the interests of all investors and those may sometimes come into conflict with their own interests.
Almost all LPA documents are different in terms of the responsibilities of the LPAC, but I imagine we will see more consistency on that going forward, perhaps including guidance from the Institutional Limited Partners Association.
Tom Angell is the leader of the Financial Services Group at Withum