This article is sponsored by Pepper Hamilton.
From fund design, through regulatory review and enforcement, the fees and expenses borne by an investment fund are a point of intense focus. The 2018 pfm Fees and Expenses Benchmarking Survey covered some of the same territory as the 2016 survey, but added a new level of granularity. And that’s exactly how funds have had to deal with fees and expenses over the two-year period: with a new level of granularity. “If it’s not disclosed, it can’t be charged” is a frequent refrain.
Routinely, we see investors asking for fulsome disclosure of fees and expenses on an annual basis and regulators parsing books and records and examining (in excruciating or heavenly detail, depending on whether you are a manager or an investor) expense records and comparing them to the disclosures in the fund’s offering documents. To avoid being caught with an unauthorized expense, expense provisions in fund documents are growing longer and longer.
Broken deal expenses
The 2018 survey took a deeper dive into broken deal expenses than in past years. Paying expenses when there is no investment to show for it is anathema to a healthy investor. However, a comparison with the 2016 survey showed a 5 percent drop in funds that charge all broken deal expenses to the fund and a 5 percent increase in funds that have all broken deal proceeds going to the fund.
The result is clearly favorable to LPs in funds with broken deals (ie, most funds): less expense and more income to the fund. In 2018, we added a new component to this question: how many funds provide for broken deal recoveries to go to the management company first so that it can recoup broken deal expenses or other deal-related transaction expenses, with the remaining amount going to the fund. The response was a surprising 19.8 percent.
As more costs are pushed to the fund manager, it would make sense to let them recover those costs out of broken deal proceeds. Is the timing important? Should the manager have to incur costs from one broken deal and recover proceeds subsequently for this to work? Or is it really just math and fungible dollars so that timing should not matter?
Capping fund fees
Regardless of the netting of proceeds and expenses of broken deals, is it a good idea to cap the amount of broken deal fees that the fund can bear? An overwhelming number of funds (89.7 percent) responded that they do not cap such costs – not surprising.
What is surprising is that more than 10 percent said they did. A cap on costs incentivizes managers to control costs, but isn’t the manager already incentivized to do that by the very nature of the fund business? After all, if the fund gets to carry territory, the manager is paying 20 percent of the costs (assuming a 20 percent carry percentage).
A cap on fees has an intangible cost as well. It incentivizes a manager to defer engaging consultants and legal help until later in the process after points have already been negotiated and the deal trajectory has already been established. (Readers beware: this author is in the legal business and no doubt biased against caps.)
The co-investment dilemma
Should co-investors be required to bear broken deal expenses? Most fund managers would answer this in the affirmative but find the mechanisms for sharing such costs to be challenging to implement.
The 2018 and 2016 survey both asked how many funds used certain mechanics about charging fees. Nine percent more funds (40 percent in 2018 vs 31 percent in 2016) reported that they will require a co-investment entity that has been formed to bear a portion of broken deal expenses.
So if a deal busts after the co-investment entity has been established but before closing, investors who will be funding the co-investment agree to pick up the tab for a portion of the deal costs if closing does not happen.
Half as many funds (13 percent in 2018 vs 26 percent in 2016) said the sharing obligation is set forth in the indication of interest from the co-investor.
And almost 8 percent more (40 percent in 2018 vs 32 percent in 2016) said that the broken deal expense is purely a fund expense. Lastly, fewer funds (6.7 percent in 2018 vs 10.3 percent in 2016) said they charge a fee on closed co-investment deals in order to mitigate the fund’s obligation to bear broken deal costs.
When one looks at the answers to the transaction and monitoring fees question in the 2018 survey, one can see that the trend is definitively against growth in fee income for managers. In the survey, 82.7 percent of funds responded that they either did not charge transaction-type fees or they offset such fees 100 percent against the management fee (as compared with 73 percent in 2016).
In response to the investors’ desire for greater transparency and the regulatory push for more upfront disclosure, fund expense provisions in fund governing documents are getting longer and longer. But do fund managers view the list of expense types that are chargeable to the fund as an authorization or a mandate? We asked this question in the 2018 survey and not surprisingly a large group, 36.7 percent, said that as a regular occurrence they choose not to charge the fund for something that could be charged to the fund. On the other hand, 42 percent said they would charge to the fund whatever they are authorized to.
So how can investors know which camp their manager falls into? By requesting detailed reporting on fund fees and expenses year over year. Twenty percent of funds reported in the 2018 survey that they intended to use the ILPA fee reporting template, as compared to 18 percent in 2016. That is not a big shift, but the downward step in those intending to use a modified form (28.09 percent in 2018 vs 38.06 percent in 2016) and the increase in those who were undecided on what reporting format to use (22.47 percent in 2018 vs 14.10 percent in 2016) clearly demonstrates the depth of the challenge facing managers today.
In conclusion, one more point on broken deals is illustrative of the issues funds face today on fees and expenses. In 2018, almost 4 percent more funds (13.5 percent vs 10.26 percent in 2016) said they offset their management fee 100 percent until the fund has recovered all broken deal expenses and then the offset goes to less than 100 percent. That means that the management company effectively bears all broken deal expenses and in return is allowed a lower offset provision on transaction fees.
This would only make sense for managers with significant fee income. Given the 2016 to 2018 data points on monitoring and transaction fees, the trend is clearly away from charging transaction-based fees – which is not surprising in light of regulatory developments over the years – and away from keeping fees that are charged. The result is that managers are being required to bear more and more expenses that used to always be fund expenses. Less fee revenue, more costs put management team budgets under a lot of stress, particularly for smaller funds. What are they doing about it? The survey suggests they are giving careful consideration to which service to outsource, and which should be taken in-house, presumably in a bid to reduce costs.