Many private equity fund managers are finding that they need to spend more time raising a new fund than they did with previous funds. This creates an increasing gap between the end of an existing fund’s investment period and the first closing of a new fund. It is during this fundraising gap that the calculation of post-investment period management fees becomes critical for GPs.
But how are fund-paid management fees calculated following the end of the investment period? The answer is surprisingly complex. In a survey of about 75 Asian private equity and venture capital funds, we found four dominant calculation methods.
Method 1: Based on Deployed Capital (50% of funds surveyed)
Funds calculate the management fee by applying the same management fee rate used during the investment period to a management fee base linked to deployed capital. Such a formulation values outstanding investments at their respective acquisition costs without any valuation adjustments. This approach is often used because it is generally easy to understand and provides a relatively steady cash flow.
Method 2: Based on Prior Period Management Fees (17% of funds surveyed)
The amount of fees to be paid in a given period is set off the amount paid in the prior period. For example, the management fee for any year following the end of the investment period could equal 85 percent of the management fees paid in the prior year. Alternatively, the management fee could be based on an annually decreasing rate, say, 1.85 percent p.a. in the first year after the end of the investment period, 1.70 percent p.a. in the year thereafter, and so on, based on commitments. All the funds that adopted such a method were venture capital funds. As compared to Method 1, the level of decrease in management fees in this method is much more moderate. Proponents of this method sometimes argue that the acquisition cost of an investment is a poor proxy for the investment’s worth.
Method 3: Based on Deployed Capital, Adjusted for Write-Downs (11% of funds surveyed)
The fee calculation is based on deployed capital, with further reductions for the amount of write-downs suffered by investments still held by the fund. The theory is that the sponsor’s management fee should decrease alongside an impairment of the portfolio’s value so that all parties share the pain. Some sponsors resist this method, as write-downs can be temporary. Method 3 can be varied to reduce deployed capital by only the amount of any net write-downs of unrealised investments, meaning that any write-downs in the portfolio would be offset by the amount of write-ups. From the sponsor’s perspective, the “netting” mechanism reduces the potential dislocation arising from temporary write-downs.
Method 4: Based on Deployed Capital, but Subject to Reduced Rate (18% of funds surveyed)
This method achieves a management fee step-down by applying a reduced management fee rate to a base linked to deployed capital. Such calculation methods may be further subject to reductions for either gross or net write-downs of unrealised investments.
Many management fee formulae incorporate other variations, including fee caps and fee floors, blended fee rates, fixed annual fees, fee reviews by an advisory committee, adjustments for reserves created for making follow-on investments, and allowing fees to step down later than the end of the investment period.
In conclusion, we found that funds that target growth- or later stage-investments often collect fees based on deployed capital, whereas funds that target earlier stage investments often collect fees based on committed capital or at least provide for a relatively more stable management fee stream.
However, there is no “one size fits all” approach, and in setting management fees the sponsors and investors should consider the fund’s and the sponsor’s specific needs and historical practices.
Geoffrey Chan is a partner at Ropes & Gray in Shanghai. Vincent Ip and Chune Loong Lum also contributed to this commentary