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The GP Series Part 5 – Management Fees and the Importance of Being Fair

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:

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:

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.

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