PEF: Management fees are about alpha and alignment

This article is sponsored by PEF Services

We have all heard the comments and read the articles highlighting investors’ concerns about fees paid to private capital fund managers.

And while carried interest clearly aligns with performance for investors, management fees are more contentious. But, how does a firm operate without income? This obstacle is especially problematic for the next generation of managers who need a budget to attract talent and build infrastructure.

Private equity is an alpha asset class where manager selection is, by far, the driver of success for investors. And, the next generation of managers is also critical to the long-term success of this asset class.

So when investors view commitments as an expense management exercise, they tend to limit their chances of working with a successful, established fund manager or limit the resources required by a new fund manager for success. There needs to be a balance where investors are confident that they are getting value for their fees and fund managers have sufficient budget to successfully operate. Until then, management fees will be a constant source of pain for the industry.

It used to be simple – firms charge 2 percent of committed capital until the investment period was over and then 2 percent of invested capital while you start raising your next fund. But that was when funds were smaller and firm operations were simpler.

Nowadays, firm operations are more complex and cover all aspects of business, including cybersecurity and compliance. The determination of what is covered by management fees versus partnership expenses is also more complicated. And, on top of all that, formulas for management fees are complex and unique to different investors. Fee offsets are waning and more disclosure is required when used, but other nuances are gaining scrutiny by investors and regulators. So, we are making progress but the goal line keeps moving.

Old fund/new fund

Since we can’t address all issues in one article, we’ll focus on some real pain points for GPs and LPs. Spoiler alert, it all comes down to alignment.

Let’s tackle the transition between the previous fund and the new fund. This is a tricky time. GPs want legacy LPs to commit to the new fund but they also want to expand their investor base. So, when do you start charging management fees on the new fund?

According to our survey, starting the management fee at “closing” is declining while starting the clock ticking on the first capital call is increasing (and yes, subscription lines are also impacting these trends, but that is a topic for another article). Also, there was a pick-up in funds not charging management fees on the new fund until the former fund’s investment period is over (which typically triggers a step down in management fee formula).

While it might be hard to piece it all together, this makes sense as investors don’t want to pay twice for something but as a fund winds down, so too does its management fee. Also, subsequent funds might trigger additional infrastructure spend, so the firm can’t wait too long to start collecting additional management fees. The ability to earn additional management fees to continue to support and build the firm is one of the economic drivers for GPs to start their next fund and contributes to the alignment of GPs and LPs.

Let’s dive a little deeper into how management fees work in this post-investment period.

In theory, the GP has a successful fund winding down and a new fund ramping up. Management fees formulas have two basic components – percentage and base. The step-down period typically adjusts only one of them.

For the majority in our survey, the base was adjusted. In those cases, the base went from committed capital to “invested capital” less unrealized depreciation and write-offs (since they are no longer in the cost). And, as long as the GP is initiating a new fund, this approach should not disrupt alignment.

‘Invested capital’

There are many questions and potential points of misalignment. For starters, what exactly is ‘invested capital’? Is it determined by capital invested by the LP, or capital invested in the portfolio?

To the extent the base is cumulative paid in capital of the investor, what is the impact of recycled proceeds? What if the manager decides to use income from investments (eg, debt funds) for fees and expenses of the fund? Should the term ‘invested capital’ for an investor be grossed up to include these amounts?

Should managers issue a net capital call/distribution documents so that these amounts are more easily tracked? For fund of funds, this scenario can get even trickier as proceeds from one fund can be used to fund a capital call for another fund.

What if proceeds are used to pay down a subscription line as opposed to calling additional capital? Without disclosures and supporting documents, any type of recycling (which is a good cash management practice) can cause a lot of confusion on the calculation of the management fee base.

There are a few overarching themes to address the numerous questions. If the paid-in capital amount is calculated at a point in time, net of distributions, recycling doesn’t create a problem since investors would be in the same economic position as if the fund did a net capital call/distribution. However, the risk of the manager deferring distributions to investors increases. Another potential alignment issue.

‘Invested capital’ could also be cost basis for the fund’s investments. Are guarantees included? What if the fund is providing the collateral for a third-party loan to the portfolio company? If the fund is receiving the fees for guarantees and collateral, shouldn’t the manager also be receiving a fee for managing those ‘investments’?

Keys to success

Two key practices: First, make sure everyone knows the full cycle of management fee calculations and how the base is calculated. Second, disclose and document every item that impacts the base and the percentage. Many investors are doing fee recalculations, so make it easy for them.

Unless investors and GPs can both understand and easily explain/disclose information about management fees, they will be a constant source of pain for the industry and could dampen our industry’s ability to foster the next generation of firms.

Management fee income is crucial for fund managers to build their team and firm infrastructure, especially in the firm’s first 10-15 years. Once you get past fund IV, things get a bit easier to manage, funds tend to be larger and management fee income more predictable. At that point, investors should start having conversations about expense management balanced with succession planning because it is still all about the alpha.