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.