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The Importance of Management Fees

Management fees play a crucial role in private equity funds in that they permit the fund manager or general partner (GP) to generate an income stream from the fund to cover its costs for operating and managing the fund. At their core, management fees are designed to provide fund managers with the ability to pay salaries and cover overhead expenses such as office space associated with running the fund or funds. This directly translates into the fund’s health (recall funds’ reliance on attracting and retaining key persons) and consequently returns for the limited partners (LPs). Just as important from a fairness standpoint is the management fee offset, which credits back to the fund, and therefore the LPs, external streams of income generated by the GP and that are related to fund. This article discusses in detail the management fees and offsets in private equity funds and best practices in fund management that provide for fairness to managers and LPs.

The Purpose Drives the Fees

As noted earlier, the core function of management fees is to provide fund managers with income streams that permit them to pay salaries, retain advisors, and cover costs related to managing the fund, be it direct costs such as travel or overhead such as office rent (more on this below). It is important to establish a premise at the outset, which is that to align the financial interests between the fund managers and investors, it is universally accepted that fund management salaries are decent, but not handsomely rewarding, pushing fund managers therefore to rely on carried interest and fund returns for rewarding paydays. With that premise in mind, because the costs associated with running a fund change over the course the fund’s life cycle, it is only logical that the management fees charged by the fund manager to the fund also change overtime. The typical private equity fund has 3 life stages:

• Investment period – During the investment phase of a fund’s life, the GP will be occupied with sourcing and making investments. For this reason, the management fee is at its highest and paid in advance every quarter. Market standards are at 1.8% to 2% during this period, but can fall outside this range for single asset funds (lower) and highly diversified or EM funds (higher).
• Harvesting period – After the investment period, the fund is no longer able to make new investments. Therefore, the GP’s role is reduced to support existing investments, review and report on them, and sell or liquidate the positions. Due to the reduced role, GPs should expect that management fees will stepped down. We customarily see reduction of 0.25% quarterly to a minimum of 1%. At this point, however, the GP and key persons should also be able to raise or close on a subsequent fund, permitting them a new stream of management fees.
• Extension period – By standard, private equity funds have a term of 10 years. However, the GP can choose to extend the fund by 1 or 2 years to allow it additional time to liquidate some final fund assets and distribute proceeds. Because this is elective to the GP, who is holding on to the assets to maximize their value (and its carried interest), and because the costs are very limited to liquidating final assets, standard market practices provide that the fund will not pay to the GP a management fee during extension periods unless the LPs agree otherwise.

The management fees and stepdown structure are customarily set out in a very clear manner in the limited partnership agreement (LPA) or fund terms and conditions to allow the investors to understand them and examine them clearly.

Inclusions in Management Fees

Management fees are directly related to the reasonable costs of operating the fund. How management fees are derived should be transparent to LPs and investors just as they are to the GP to prevent conflicts of interest and a negative feel of being overcharged. Costs that GPs should expect to be covered by the management fee include:

• Conferences, research and information services, and computers and software;
• Consultants and advisors retained in relation to fund investments;
• Travel and entertainment;
• GP regulatory compliance costs, licensing costs, and cost for maintaining books and records; and
• Office space, furniture, facilities, and communications costs.

Management Fee Offsets

Private equity fund managers or GPs can generate income streams outside of management fees in connection with the fund. Examples of these streams include board membership fees received from fund portfolio companies, monitoring fees or transaction or broken deal fees from fund investments, and advisory fees from portfolio companies or in connection therewith. Because the fund manager is receiving the management fee to manage the fund, fairness and alignment of financial interests dictate that it should not also receive fees from fund portfolio companies or investments. As such, it is a standard practice that the types of income streams noted above, if received, would be offset against the management fees. Market practice in this regard is that 100% of such other fees would be offset against management fees payable by the fund. That said, we do see at times offset provisions that provide for a lower offset percentage, or that permit the GP to charge management or other fees in connection with co-investments along the fund. The provisions relating to the offset are usually reflected in the fund terms and conditions or LPA.

The GP Series

The GP Series is a series of practical guidance notes prepared by Hammad & Al-Mehdar’s PE and VC team that are designed to guide GPs and practitioners on best practices relating to private equity fund management.

The attorneys at Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards. Contact us today to discuss how we are able to support the legal demands of your private equity fund.

A cross-discipline Hammad & Al-Mehdar team advised Tarabut Gateway on its $13 million series seed financing, led by Berlin-based venture capital firm Target Global, and joined by Kingsway Capital, Entrée Capital and regional investors: Al-Zamil Investment Group, Global Ventures, Almoayed Technologies and Mad’a Investment.

The round is the largest fintech seed round in MENA, and a promising 2021 start for the ecosystem and the fintech industry.

Tarabut Gateway is MENA’s largest regulated open banking platform, licensed by the Central Bank of Bahrain. The platform enables the collaboration between financial institutions by accessing financial data of the partner bank’s customers and allowing them to build new apps and services. Currently, Tarabut has offices in UAE, London, Manama, and is planning to expand regionally.

The HMCo team was led by partner Abdulrahman Hammad, and included Samy Elsheikh, Tarek Bilani, and Layla Tatwany.

Hammad & Al-Mehdar partner Abdulrahman Hammad and senior associate Samy Elsheikh author the Saudi Arabia chapter of The Mergers & Acquisitions Review, 14th edition, published by Law Business Research.

The chapter provides a deep dive into the relevant laws and regulations relating to the Saudi Arabia’s M&A sphere, and is an important comparative reading for counsel and managers looking acquisitions or divestitures in the Kingdom.

The chapter is available for download here.

The Central Bank of the Kingdom of Saudi Arabia (known as “SAMA”) announced its preliminary open banking policy on 10 January 2021. The policy was introduced on the back of recent moves by SAMA to bring innovation to the financial and banking sectors, including the launch of a fintech regulatory sandbox and the introduction of regulation governing payment service providers, in line with the Kingdom’s Vision 2030 agenda and the Financial Sector Development Program.

The open banking policy will allow consumers to share their data with third parties in a secure manner. Potential benefits of this include the facilitation of payments, aggregation of financial data, and access to better financial products and offerings. According to the published policy, SAMA’s journey to launch is in three different phases: The first phase will focus on the design of the open banking ecosystem and the governance of the market participants (a majority of which will likely be SMEs). This will be followed in the second half of 2021 by the implementation phase, which will include testing with financial market participants and an enhancement of customer’s awareness. Lastly, the system will be fully formed and will go live by 2022.

We expect that SAMA will start accepting applications from market participants very soon, with such applications likely to be made through the SAMA SandBox or other channels as SAMA dedicates. We expect SAMA to announce its complete open banking policy and regime during the first half of 2021.

Both vesting and earn out provisions are important tools used by investors to mitigate some aspects of future business uncertainty, especially in relation to growth-oriented valuations. This article discusses how these two tools are relied on by investors to this effect, and how the companies or management may better negotiate such provisions towards a successful transaction.

Vesting Provisions

A vesting provision delays the earning of the full entitlements of shares or stock to founders or management of a company to be pursuant to an agreed vesting schedule, usually over three or four years. If the individual subject to vesting leaves the company before the vesting period is complete, the company has the right to cancel or buy back the unvested shares at the lower of cost or fair market value.

Vesting provision are often used for shares issued to a founder of a company and for ESOP shares, options, or participation rights. Because founders and senior managers receive compensation made up of both cash and equity, subjecting the equity to vesting essentially conditions part of the compensation on the continuity of service during the vesting period, thus decreasing the likelihood that the person would voluntarily leave and therefor increase the business risks, and also tying the fortunes of the employee to the those of the company he/she is serving. The leave risk is particularly acute in startups, where the product or service is significantly less valuable than the management team. Additionally, if the founder does choose to leave, the cancelled or returned shares give the company firepower to recruit and incentivize a replacement without diluting as much value from the remaining shareholders.

The most common vesting period is 36-48 months. The vesting shares gradually vest over the vesting period, often monthly or quarterly. Once vested, the shares are fully owned by the founder with no risk of loss. The provision might also include a “cliff,” meaning that the initial vesting interval is longer, with more regular vesting occurring only after the cliff has passed. Customarily a cliff of 1 year is imposed on vesting shares.

One of the most contentious parts of a founder departure is whether they a “good leaver” or “bad leaver.” Any time a founder leaves for cause, they are clearly a bad leaver. A founder is a good leaver if they are asked to leave under positive circumstances, such as when the business has reached a certain level of maturity and the founder is no longer the right profile fit for the company’s needs. Good leaver and bad leaver provisions customarily impose additional or less vesting on to the standard vesting structure. Where it gets most complicated is when the founder chooses to leave. Many believe that this is automatically a bad leaver scenario, while others argue that there is not a one size fits all scenario. For example, the founder may be suffering from illness forcing his/er departure.

Earn-Out Provisions

 An earn-out is an agreement between the seller and buyer of a target company where some or all of the selling price is contingent on the future performance of the business. An earn-out is used to shift the risk from the buyer to the seller while still preserving future upside gains for the seller.

An earn-out provision is used in private equity and venture capital as a mechanism for bridging the difference in valuation perspectives regarding the target company. If an earn-out is employed, the seller or company agrees to accept a lower initial valuation for the prospect of benefiting if the business prospers through the incoming investment or purchase.

An earn-out is considered a fair method for addressing a scenario where a company or a seller believes the future value of the company is high, but the investor or buyer has concerns given the current business, economic state, or forecast assumptions. An earn-out allows the company or seller, who know the business better than the incoming buyer, to benefit if the business meets its projections. In cases of venture capital investments, earn outs permit the founders to benefit from achieving their projections where the investment valuation is below such projections.

There are a number of important considerations when including an earn-out provision in a sale or investment:

• Choose a metric for the earn-out. Targets are normally financial targets, such as revenue, but could also be milestones specific to an industry. This will be a heavily negotiated aspect of the provision because both parties will seek to choose a metric whose data can’t be manipulated. The more objective and straightforward the metric, the more likely the earn-out will be accomplished without dispute.

• Consider timing. The provision will need to detail the timing of payments and length of the earn-out period. The most common time frame is somewhere between three and five years, but in venture capital investments it can be as short as one or two years. Interim targets are a tool that can be utilized if there is a struggle to reach consensus on the length of the earn-out period. An earn-out will often include interim payments or valuation adjustments on a set schedule assuming targets are met. Most earn-outs will include a cap on the possible valuation and sellers will negotiate a floor.

• Control over the business. Earn-outs can be cumbersome to buyers and investors if there are restrictions placed on their control of the business. Sellers or companies, on the other hand, face legitimate concerns of not securing their earn-out if the business is mismanaged. Selection of appropriate benchmarks that ensure both the seller/company and buyer/investor win when they are achieved lessen the conflict over control. In instances of sale of control, the parties will need to work through these difficult questions, including whether the target business must be kept separate from the rest of the buyer’s company. The buyer and seller should work together to develop a growth plan and define the investments and actions needed to accomplish the goals.

• Incentives for key employees. Often the future potential of a business depends on key employees staying in role. If this is the case, consider including incentives for these key employees if performance metrics are met. Also consider coupling earn outs with vesting provisions.

• Protection against change of control. To safeguard against a scenario where the buyer sells the company during the earn-out period, the seller should negotiate for immediate vest language in the provision. Under such a provision, the deferred payments would immediately vest upon a change in control.

The most important guidepost in drafting an earn-out provision is to strive for clarity. Earn-outs can provide significant benefits to both a buyer/investornd seller/target and ensure that a company continues to perform successfully. If, however, the provision is drafted vaguely, it leaves open significant possibility for disputes between the parties.

If you are dealing with complicated business structuring questions, including around vesting and earn-out provisions, it is important to work with a firm with deep expertise in supporting M&A transactions. Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards, and boasts an award winning M&A practice. Contact us today to discuss how we may be able to support the legal demands relating to your M&A transaction.

The Role of Key Persons in Private Equity Funds

A “key person” is an important employee or executive who is crucial to the operation of a business. They are generally considered to have skills, knowledge, leadership abilities, and experience that is critically important to business success. The death, absence, or disability of a key person is likely to have significant negative side effects on the operation of the company.

If one or more key persons have been identified as critical to the success of a business, it is important to secure necessary protections relating to the involvement of that key person.

Private equity, venture capital, and, to a certain extent, hedge funds often are built around a number of key persons in recognition of their ability to drive returns to the investors that trust in them. These key persons tend to raise the fund, manage its deployment, and run the deployed portfolio of investments. As such, these trusting investors tend to seek protection from events that impact these key persons’ dedication to the fund. After all, investors do not want to hand over money to be managed by a junior team of resources.
So important is this protection that ILPA (Institutional Limited Partners Association) principles, which are largely accepted as market standard for private funds, dictate that key persons in a fund should devote substantially all of their business time to the fund, its predecessors and successors within a defined strategy, and its parallel vehicles. The ILPA principles go on to provide that a key person to a fund, as identified by a Limited Partnership Agreement (a “LPA”), should not act as a General Partner (“GP”) for a separate fund managed by the same firm with substantially equivalent investment objectives during the investment period of the fund in which he is a key person.

The ILPA Model LPA language below provides an example of standard language governing the key persons’ time dedication to the fund:

• 9.1 Successor Fund. Until the earliest of (i) the termination of the Commitment Period, (ii) the date when 80% of Commitments have been funded, invested, committed or reserved for investments (including Follow-on Investments) or funded or reserved for Fund Expenses; (iii) the date when 60% of Commitments have been funded for investments; and (iv) the termination of the Fund, the General Partner and the Fund Manager shall not, and hereby commit that none of their Affiliates shall, directly or indirectly, accrue any management or advisory fees relating to any vehicle or account (other than any Fund Vehicle), having investment objectives that materially overlap with the Investment Objectives (“Successor Fund”), in each case except with the prior written consent of a Majority in Interest.

• 9.2 Time and Attention. Prior to the termination of the Commitment Period, the General Partner shall cause each of the General Partner, Fund Manager, and the Key Persons to devote substantially all of such Person’s business time to the affairs of the Fund, the General Partner, the Investment Manager, any Alternative Vehicles, any Parallel Vehicles, any co-investment, Prior Funds, or other investment vehicles permitted by this Agreement. After the termination of the Commitment Period, the General Partner shall cause each of the General Partner, Fund Manager, and Key Persons to devote that portion of their time to the affairs of the Fund as is necessary for the management of the Fund.

Key Person Provisions in the LPA

Because key persons are the individuals on whom the success of the fund is highly dependent, any significant change in those individuals or event impacting their ability to dedicate to the fund the agreed amount of time and attention should allow investors in the fund (referred to as Limited Partners or “LPs”) to reconsider their decision to commit to the fund, and changes to key persons customarily require the approval of limited partners’ advisory committee (“LPAC”) or a majority of the LPs.

Where a key person event takes place, market standards in private equity and venture capital dictate that the investment period of the fund, and thus the GP’s ability to call on capital commitments to make new investments, would be suspended. If this happens, the GP will customarily devise a plan to remedy the event, including proposing alternative key persons, and submit such plan to the LPAC or LPs to seek approval to lift the suspension. If the suspension is not lifted after a period of time (usually between 90 and 120 days) the fund’s investment period will permanently be terminated, and the fund will no longer be able to make new investments.

Fund Manager Growth

Fund managers grow through attracting more investor funds or ‘assets under management – AUM’. AUM determine the level of management fees that the fund manager is able to generate in aggregate across its various funds, which directly tie to its ability to grow its team and resources, and thus identify and manage more and better transactions. The conundrum in which fund managers find themselves in in light of the key person principles, which is acute for fund managers who are negotiating the terms of their first fund, is that key person principles significantly restrict the fund manager’s ability to raise a second and a third fund during the first fund’s investment period, which is customarily 4 to 5 years from the fund’s first closing. This is understandable because on one hand the fund manager’s key persons should – and want to – focus their time on the fund, but on the other hand the fund manager’s management team wants to grow the business.

One way to solve for this is for the fund management company to expand its pool of senior fund managers who can act as key persons for different funds. This customarily requires the founding managers to give up some equity, but it also drives efficiency because some resources can be shared across a number of funds.

Additionally, the GP can seek to mitigating some of the restrictions noted above, and one such mitigant, which is utilized in the above quoted ILPA Model LPA provisions, is for the GP to negotiate that the launch of a successor fund be permitted when the [original] fund is ‘fully invested’. In such scenarios, the concept of ‘full investment’ is defied in the LPA and customarily means the investment or reservation for investment of 75% to 80% of aggregate fund commitments. The GP may also seek to define the ‘launch’ of a successor fund to either closing on such fund, thus permitting itself to market and raise the successor fund without violating the original fund’s LPA, or to drawing management fees from the successor fund. LPs will customarily negotiate additional parameters to how ‘full investment’ can be achieved, such as restricting the GP’s ability to reserve commitments for follow-on investments to 15% or 20% of the aggregate fund commitments.

In the end, fund managers should reach a balance between restrictions on growth imposed by their funds’ LPs and their own growth strategies.

The GP Series

The GP Series is a series of practical guidance notes prepared by Hammad & Al-Mehdar’s PE and VC team that are designed to guide GPs and practitioners on best practices relating to private equity fund management.

The attorneys at Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards. Contact us today to discuss how we are able to support the legal demands of your private equity fund.