EM Pro Tips: Management Fees
Management fees in traditional closed-end funds follow a standard structure but include important nuances that emerging managers should understand. While they may seem like a simple calculation of commitments multiplied by the fee rate, the structure can vary significantly based on fund strategy, lifecycle stage and fee offsets.
Standard Management Fee Structures
Most private funds charge an annual management fee based on a percentage of committed or invested capital. The industry standard typically ranges from 1% to 2%, with variations depending on fund size, strategy and lifecycle.
Investment Period (First 3-5 Years): During the investment period, the management fee is generally calculated as a percentage of committed capital.
Post-Investment Period: The fee often steps down to a percentage of invested capital or net asset value, leading to a decline over time as investments are realized. Typically, the fee is based on an invested capital formulation; however, credit funds and other similar strategies may use a net asset value formulation. Invested capital typically refers to the capital used for investments, including investment-related expenses, minus amounts realized, written down or written off.
Nuances in Management Fee Structures
Step-Down and Events Affecting Investment Period
After the end of the investment period, management fees typically decrease, but the timing and structure vary. Some funds implement a simple automatic step-down following a certain number of years, though the majority of funds will also tie it to an event that can end the investment period earlier than expected.
Invested Capital Write-Off vs. Write-Down Formulations: If the invested capital formulation relies on write-offs, then a portfolio company must be completely written off before affecting the fee calculation. This is obviously a preferable formulation for emerging managers as it requires the portfolio to be completely written off before affecting the management fee calculation. However, if the formulation relies on write-downs, then a partial loss impacts the fee, which is less favorable for managers. If agreeing to this, managers should try to negotiate a threshold (e.g., at least 50% written down) and ensure it is permanent rather than a temporary market fluctuation. Many managers argue that invested capital should only be reduced for permanent write-offs, as write-downs often require more active management of distressed portfolio companies. By contrast, fully written-off investments require little to no ongoing management and successful companies often require minimal day-to-day involvement..
Key Person Events, Successor Fund Launches, For Cause Events, No-Fault End of Investment Period: These events can accelerate the step-down in management fees as they typically cut short the investment period or directly affect the fee calculation. Emerging managers should carefully review how key person event definitions, successor fund launches or other events and the investment period definition interact to avoid unintended fee reductions.
Strategy-Specific Fee Structures
The management fee structure varies by fund strategy:
Private Equity: Traditional private funds typically charge around 2% of committed capital during the investment period and 2% of invested capital thereafter.
Credit Funds: Credit funds often have lower fees, calculated on an invested capital or NAV basis without a step-down, distinguishing them from traditional private equity structures.
Transaction and Placement Fee Offsets
Transaction fees received by general partners from portfolio companies usually offset 100% of the management fees. Emerging managers should try to negotiate a lower transaction fee offset, e.g., 80% or 70%, though they should keep in mind that the market standard is now 100% offset. Therefore, they should be prepared with a strong rationale for why a lower offset is necessary.
Additionally, placement fees incurred by the fund are also offset against the management fee. Typically, investors do not directly pay placement fees; however, they may be willing to front the cost provided that it will be recouped through a management fee offset.
Final Thoughts
While management fees may seem straightforward, their details significantly impact an emerging manager’s long-term success. Unfavorable terms can hinder operations or lock managers into managing a fund with insufficient fees. Understanding and negotiating these nuances upfront is critical to ensuring a sustainable and well-structured fund management approach and avoid surprises.
