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2007 Fund Formation Terms and Trends - Part 2 of 2

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Fees and Expenses - Management Fees

Management fees are necessary to pay for the ongoing operating expenses of the partnership. Of course, all investors feel that the management fees should be reasonable to assure the ongoing operation of the partnership.

There has been some criticism of management fees, especially in light of the larger funds raised because excessive fees can potentially represent a misalignment of interests. The argument is that an annuity stream of undue management fees can reduce the financial motivation of general partners to achieve high risk-adjusted returns.

The typical arrangement is for a fund to charge an annual fee of 1.5% to 2.5% of total committed capital. Management fees seldom fall below 1.5% and the carried interest to the general partners seldom rises above 25%. There are alternatives: budgeted fees are perceived by many LPs to be an improvement over the flat management fee structure. Additionally, scaled fees are also useful for reflecting the higher level of effort by the general partner during the earlier years of the partnership, when the deal-making and due diligence efforts are more intense. Most funds polled had some sort of scaled fee structure, and due to the varying range of responses we received in the data, it follows that management fee structure remains an area of negotiation.

Budgeted Fees: Good in Theory, Not Prevalent in Practice

Budgeted fees are management fees determined by the budgeted annual operating expenses of the fund. Typically, an annual budget is presented to the advisory board for approval. Conceptually, this seems to be a method that creates accountability and implies a better alignment of interests. There is no research that indicates budgeted fees reduce potential investment returns.

Budgeted fees are viewed somewhat negatively by GPs, the often cited concern being that LPs or Advisory Boards would be micromanaging the partnership; negotiating budgets would not be a good use of time; budgets create "cost-plus" thinking; and, "our budget is proprietary information."

Sliding Fee Scales

A sliding fee scale is a management fee that varies over the life of the partnership. Typically these are negotiated fees that attempt to recognize the higher level of due diligence and analysis required during the earlier years as the partnership makes investments. The fees are higher during the earlier years of the partnership, declining over time, so-called "tails."

How is the Fund Management Fee structured?

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Transaction Fees

The late Dick Testa was the first to realize that, if fees payable to members of the general partner or to the general partner itself for various services to portfolio companies were, in turn, paid over to the investor partnership, those fees could be treated as Unrelated Business Taxable Income ("UBTI") or income effectively connected ("ECI") with a trade or business in the United States. Accordingly, if the bargain is that those fees and payments (including the value of director's warrants as of the date of grant) are to be credited to the accounts of the limited partners because it is their money at risk, then the idea is to apply those fees as an offset of the management fee.

The most common transaction fees, buyout funds principally, are revenues earned from investment banking activities, break-up fees, and in some cases, consulting/managerial fees (when a GP takes an active managerial role in the company). Other fees also include compensation to fund-nominated directors.

In the past, general partners received all such fees and the fees did not count against the GPs management fee income. Limited partners soon realized that such fees, which could be quite large, were being earned from their investment capital.

The market standard now is for general partners to split such transaction fees with limited partners at some negotiated percentage.

37% of the funds indicated they could keep 100% of the fees. This was a significant increase from the last survey.

One interesting comment was that a 100% management fee offset was triggered after $150,000 in fees (per year) had been collected. One creative structure was to have an offset of "50% or less if applied to a portfolio company and 100% offset if the investment was lost."

How does the fund address "Transaction" fees (including directors' fees)?

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Trend from 2004 to 2007.................

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