Apologists for the retention of a ‘market standard’ management fee in the face of ever larger fund sizes frequently cite the economic model of supply and demand as justification. Current evidence, they point out, indicates that hunger to access brand-name LBO funds overrides concern about the level of fees being charged by these vehicles. However, the temptation to view fee-charging as a non-issue in today's climate should be resisted. As demonstrated by the tables below, the allegation that outsized fees diminish the principle of alignment of interest is in fact being wielded by smaller funds as a weapon on the fundraising trail.
The tables formed part of a sales pitch used by a midmarket buyout firm (which has elected to remain anonymous) when it was last marketing a fund to potential investors. They demonstrate that a €5 billion ($6.6 billion) fund charging standard management and transaction fees stands to garner almost eight times the fees levied by a €500 million fund also applying market standard. Assuming that the €5 billion fund has only 3.5 times the number of investment professionals, this means the level of fee income per professional is more than twice that of the €500 million fund.
The point of the illustrations is to make the case that a smaller fund has better alignment of interest with its investors and also perhaps to sow seeds of doubt about whether carried interest provides sufficient performance incentive in a strongly fee-based model. Caution needs to be exercised here: the illustrations used are based on hypothetical rather than real-life examples and the assumptions behind them may therefore be questioned. Nonetheless, the very fact that they are being utilised in GP/LP discussions underlines the important point that the issue of appropriate fund economics is still a live one.