When Securities and Exchange Commission chairman Gary Gensler spoke to the Institutional Limited Partners Association in November last year, it was clear that private capital management fees were troubling him. In particular, he was perturbed that the two and 20 fee model has persisted, largely unchanged, despite a meteoric growth in assets under management. But these are headline figures only. In reality, the management fee calculation is a great deal more complex.
First, there is the question of how monitoring, financing and transaction fees are offset against the management fee itself. The treatment of these fees has proved contentious in the past and the SEC is particularly resistant to the use of so-called accelerated monitoring fees, where managers earn a lump sum in the event of a portfolio company being exited early.
Firms to have fallen foul of inadequate disclosure around accelerated monitoring fees include TPG Capital and more recently Alumni Ventures. Under the SEC’s latest proposals, meanwhile, accelerated management fees would be banned altogether.
The impact of this particular rule change would be minimal, however. The majority of firms have not only moved away from accelerating monitoring fees, but effectively from charging them altogether. In the latest Private Funds CFO Fees and Expenses Survey, 39 percent of firms no longer charge monitoring fees, while 42 percent offset them completely against the management fee – essentially negating their existence. A similar story plays out against all other forms of transaction and financing fees.
“Several years ago, the management fee was offset by 50 percent. And if at the end of the life of the fund there were still unapplied offsets, that money was distributed to the LPs,” says Saw Mill Capital CFO Blinn Cirella.
“That percentage started to increase from 50 to 75 to 80 and is currently 100 percent for most funds. So, there is no real benefit to charging those fees if you are just going to reduce the management fee collected accordingly.”
The management fee charged to investors is also impacted by the point at which it first comes into force, and the point at which it is terminated. Almost half of respondents to the 2022 survey begin charging the management fee at first close, while only 30 percent wait for the first capital call. This is controversial.
“LPs don’t really want to be paying management fees until they actually make an investment,” says Cirella. “It can also have a negative impact on performance if the fund calls capital for management fees early in its life, while accruing the fees would create a drag on NAV.”
Furthermore, Cirella adds, the period between first and final close can sometimes be as long as two years. “LPs can feel like they are paying for nothing.”
Then there is the question of how management fees should be handled at the other end of a fund’s life. The survey found that 82 percent of respondents switch from a fee based on commitments to a fee based on invested capital, while the remainder employ a step down on the committed capital rate.
“Many investors look for the management fee to start with the first investment and they look for it to terminate at the end of term. In short, investors do not want what seems to be a never-ending fee,” says Stephanie Pindyck-Costantino, a partner at law firm Troutman Pepper.
“Some of the larger houses continue to run the management fee through wind up, under the premise that that is when some of the hardest work occurs. Others argue that that is what liquidation fees are for. Crucially, the language around the mechanics is getting tighter and tighter.”
“LPs don’t really want to be paying management fees until they actually make an investment”
Saw Mill Capital
Cirella adds: “I think reducing the management fee from commitments to invested capital after the end of the investment period makes sense. As deals are sold the management fee continues to be reduced and I think this is fair as the amount of work required to manage the fund lessens with each sale. I also think that once a fund exceeds its extension periods the fee should be reduced to zero.”
Provisions around fund extensions, as well as fund restructurings, are often still overlooked in documentation, however. Over three-quarters of respondents do not stipulate who pays costs relating to a potential fund restructuring, while 62 percent do not stipulate fees and expenses arrangements in the event of an extension. This is important, because given the current economic maelstrom, both of these eventualities are only likely to increase in prevalence.
“I think you’ll see more restructurings and extensions as a result of this new environment,” says Dan Rochkind, CFO at Lerer Hippeau. “For one, exit markets have slowed. As for restructurings, the industry has experienced a proliferation of first-time funds or new managers.
“As the environment becomes more challenged, I think you can expect some of these new managers to exit the industry and/or attempt to close down their funds through strategic secondary sales. Indeed, at Lerer Hippeau, we’re currently managing a few portfolios that were the result of these types of events.”
Rochkind believes it is important for GPs to be clear with investors regarding expectations on the timing of liquidity and fund wind-downs in an extension period.
“Management fees and expenses also need to be clearly and precisely agreed upon as part of this discussion to ensure that interests are aligned between the GP and LP,” he says. “In my experience, LPs are pretty understanding of the work that needs to be done during an extension and recognize that GPs need the resources to complete the fund wind-down properly.”