Fees, Fees and More Fees--PE and VC Fee & Expense Data Comparison from 2004 to 2007

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

7 minutes to read

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?


All Funds VC Funds Buyout Funds
Average 2.12% Average 2.36% Average 1.94%
Median 2.00% Median 2.50% Median 2.00%
High 2.50% High 2.50% High 2.50%
Low 1.00% Low 2.00% Low 1.50%

All Funds 125-249mm 250-499mm 500-749mm 750-999mm 1000mm >
Average: 2.20% 2.13% 2.11% 2.17% 2.25% 1.71%
Median: 2.25% 2.00% 2.00% 2.00% 2.50% 1.50%
Buyout Funds 125-249mm 250-499mm 500-749mm 750-999mm 1000 mm >
Average: 2.04% 2.05% 2.03% 2.00% 1.75% 1.54%
Median: 2.00% 2.00% 2.00% 2.00% 1.75% 1.50%
VC Funds 125-249mm 250-499mm 500-749mm 750-999mm 1000mm >
Average 2.35% 2.40% 2.33% 2.33% 2.50% -
Median 2.50% 2.50% 2.50% 2.50% 2.50% -

All Funds VC Funds Buyout Funds
Average 2.21% Average 2.40% Average 1.95%
Median 2.40% Median 2.50% Median 2.00%
High 4.00% High 3.00% High 2.25%
Low 0.50% Low 1.00% Low 1.50%

All Funds 125-249mm 250-499mm 500-749mm 750-999mm 1000mm >
Average: 2.35 1.85 2.14 2.17 2.00% 1.63
Median: 2.50 2.00 2.00 2.00 2.00% 1.63
Buyout Funds 125-249mm 250-499mm 500-749mm 750-999mm 1000 mm >
Average: 2.00 2.13 2.00 2.00 2.00 1.63
Median: 2.00 2.13 2.00 2.00 2.00 1.63
VC Funds 125-249mm 250-499mm 500-749mm 750-999mm 1000mm >
Average 2.44 2.25 2.25 2.50 - -
Median 2.50 2.25 2.25 2.50 - -

Transaction Fees

Many private equity firms, especially in the buyout segment of the market, periodically receive income from fees that they charge to their portfolio companies. LPs and GPs often agree to reduce the management fee by all or a certain percentage of the fee income the GP generates through activities related to the fund's investment.

The most common transaction fees 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).

Investment banking fees include income received from the work involved in taking a company public through an initial public offering, mergers and acquisitions advice or the sale of portfolio securities. Break-up fees (more often associated with buyout firms) are fees paid to the GP that compensate it for time and expenses if a given transaction is not consummated.

In the past, general partners received all transaction 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 transaction fees with limited partners at some negotiated percentage. Transaction fees are typically applied as a reduction to management fees.

Payments directly to the partnership incur a number of tax and legal consequences most investors do not want to face. Fees for other services, such as consulting or serving as directors, paid to general partners by portfolio companies are usually shared with limited partners in the same manner as transaction fees.

Transaction fees can represent a substantial source of income to general partners, and a focus on investment banking activities can be a distraction, especially when the partnership is not fully invested.

A number of GP respondents, especially the VC firms, expressed this view. Some GPs indicated that they do not engage in investment banking activities, or if they did, all transaction fees would be passed on to limited partners.

The data indicated a wide variety of splits consistent with the carried interest (80% limited partner/20% general partner) or even the capital contribution (99% limited partner/1% general partner). Only 15% of the funds indicated they could keep 100% of the fees. Most of the LBO funds surveyed took the view that a 50/50 split was appropriate, but a number also acknowledged a trend toward an 80/20 split.

The obvious takeaway is that the market standard is for management fee offsets to be in place. More than eight out of 10 funds (85%) had a management fee offset in place of between 50% and 80% (or more).

One interesting comment was that a 100% management fee offset was triggered after $150,000 in fees (per year) had been collected. Another indicated "fees treated as a return on committed capital, not a management fee offset." 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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Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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