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Friday Letter Tying fees to expenses

It’s time for firms to link management fees more directly to the cost of running the business.  

A new spin-out has recently been shopping itself to potential limited partners by stressing it will charge management fees based on budget figures rather than fund size. The hope is it will win favour with fee-wary LPs and shorten the marketing period for its debut fund.

The budget-tied management fee doesn’t happen very often; managers don’t want it – charging flat fees on ever-larger funds produces more revenue, for one thing, and disclosing all budget expenses to LPs isn’t palatable to some GPs – and LPs typically don’t expect to get it. However, in today’s tough fundraising environment, firms are getting creative on ways to attract LPs into their fund, and especially for a new manager, the strategy could work to recruit some anchor backers.

Indeed, a recent venture capital study published by long-time LP the Kauffman Foundation argued a better option than a flat 2 percent management fee was a budget-based charge, which “offers better alignment between GPs and LPs, gives GPs sufficient capital to operate their firm, and provides LPs with transparency into firm economics”.

We won’t hold our breath waiting for this to happen, even though for some firms, and we’re thinking of those managers who raise very large funds (or series of very large funds), this would be an entirely appropriate change. As LPs are quick to remind us, management fees were originally intended to help “keep the lights on”, or pay salaries and basic operating expenses while the firm waits for carry to roll in. As fund sizes have grown, the 2-and-20 model has remained largely the same, meaning management fees – in some cases – have turned into a stable, continual source of revenue regardless of manager performance. It also creates incentives for managers to keep raising larger funds.

For managers that have passed the incubation stage of their businesses and have grown into full-scale private equity operations, the flat management fee should shift into something more aligned with the expenses of the organisation. Those expenses, which should be fully accessible to LPs, should dictate the future rate of the management fee – and if that means the firm needs to charge a 2 percent fee, then so be it. (By the way, one private equity chief financial officer told us giving his LPs full view of the firm’s expenses helps the firm justify its management fee because they have a clear idea of what the fee is paying for.)

There is something of a middle ground to this argument as well. Rather than charging a flat management fee on committed capital, which is the way most firms do it in the industry, some managers charge their fee on invested capital. In this case, the fee only kicks in once the manager actually starts making investments, as opposed to just having collected a lot of money. For example, GSO Capital Partners, the debt investment affiliate of The Blackstone Group, has always charged its management fee based on invested capital.

If large-scale adoption of a budget-based management fee is a pipedream, charging LPs fees based on invested capital is surely a step in the right direction. And if fundraising gets tougher, as some anticipate, such steps will count heavily with both existing and prospective investors.