For many years, certain venture capital firms have been well-known for charging management fees that are based on the operating expenses of the firm. New Enterprise Associates, for example, has used that model.
In recent years, though, limited partners in private equity and venture capital funds have been trying to get a better sense across the board of how their management fees will be spent. They want to see the GP’s budget, and the level of access they want to the firm’s financials varies from manager to manager.
Earlier this year, one long-time LP, the Ewing Marion Kauffman Foundation, shook up the conversation with a paper arguing that management fees based on a firm’s expenses would be more appropriate than the traditional 2 percent, especially for those firms with multiple fee streams from several funds. It’s a sentiment that industry trade group the Institutional Limited Partners Association codified in its private equity guidelines in 2009.
While it’s unlikely the 2-and-20 model will totally disappear, LPs are more than ever pushing back on a fee model
Why shouldn't GPs be as capital-efficient as they expect their portfolio companies to be?
that many consider to be a profit generator – which keeps churning whether the manager makes money or not.
“There seems to be growing support among LPs to pay fees based on the GPs’ budget needed to run the business, or on invested capital versus the capital commitment raised. Why should we pay you 2 percent when you’re on Fund VI or VII or VIII and just adding to the gross overpayment of the GP?” says David Turner, head of private equity at The Guardian Life Insurance Company of America. “Why shouldn’t GPs be as capital-efficient as they expect their portfolio companies to be? We’re only seeing the beginning of this pushing and shoving. The question is, when will change come and in what form?”
Not for profit
The issue was defined in 2009 by ILPA, which argued as part of its private equity principles that management fees should not be a profit center for GPs. “GP wealth creation from excessive management, transaction or other fees and income sources, reduces alignment of interests,” it said. ILPA recommended that management fees be based on “reasonable operating expenses and reasonable salaries”, and that GPs should provide prospective LPs with a fee model to be used to analyse and set management fees.
If you're successful, nobody begrudges you making generous money, and that's how we treat our CEOs. We'd love them to be successful and our LPs should be cheering us to make millions — but in incentive fees, not management fees.
GPs have gotten creative; many now offer varying levels of management fees depending on the size of commitments. Bain Capital, for example, is reportedly offering three different fee structures, which include a 30 percent carried interest with a 1 percent management fee and a 7 percent preferred return, or a 0.5 percent management fee, 30 percent carry and no preferred return, according to Bloomberg.
The Blackstone Group’s debt shop GSO Capital Partners only charges management fees on invested capital, rather than the more traditional model of fees on committed capital.
Many general partners, of course, push back on attempts to change the traditional fee model. However, Kauffman,
which interviewed numerous GPs and LPs for its study, said that although GPs are willing to work with LPs on different ideas, they’re not really being asked for anything different.
In fact, the study argues that it’s LPs who have been reticent to try and change the status quo – either because they don’t want to rock the boat, or because they’re content with manager performance and not bothered by the fee.
However, even some GPs agree the 2-and-20 model is in the process of shifting to a more expenses-based approach. “I think it’s inevitable we head in this direction,” says Bob More, a general partner with Frazier Healthcare, a growth equity and venture capital firm. “If you’re successful, nobody begrudges you making generous money, and that’s how we treat our CEOs. We’d love them to be successful and our LPs should be cheering us to make millions – but in incentive fees, not management fees.”
Successful funds that generate carried interest pay back management fees out of profits. So these funds aren’t really the problem, according to Steven St. Peter, most recently a managing director with venture manager MPM Capital. “In scenarios with big returns, there’s no misalignment, the management fee is just bridging cash flows. [The problem is] where the funds aren’t even returning capital, much less paying back management fees. In that construct, there’s opportunity for people to get rich in management fees while the funds lose money,” he says.
The question gets more complicated with firms that have gone public like The Blackstone Group and Kohlberg Kravis Roberts. Public unitholders of these firms like to see revenue from management fees increasing, an idea that puts them at odds with LPs looking to cut back on fees.
Don’t ask, don’t tell
While actual budget-based management fees are still rare, LPs are increasingly expecting some level of access to the budget. But they won’t always get what they want.
“We always ask GPs for a copy of the budget. But what we usually get in return is an overview of the firm’s financials and business economics,” explains David Fann, head of LP advisory firm TorreyCove
Capital Partners. “People are becoming more creative as fundraising gets harder. This [i.e. access to financials] is one approach; it satisfies issues of transparency that LPs have been looking for and demonstrates a closer alignment of interests between GPs and LPs.”
A separate LP source speaking on thecondition of anonymity agreed budget requests were being made, but that “very few GPs will actually provide them”. Those that do usually present the information in summary form, he adds, crafted in a way that implies the firm is making very little money from fees. “But there is no way for us to validate that without the financial statement.”
We always ask GPs for a copy of the budget. But what we usually get in return is an overview of the firm's financials and business economics.
However, sharing budget information could be an easy way to quell debate about a firm’s management fee, according to one chief financial officer at a private equity firm. “We’re about to enter the fundraising cycle and we plan to show our investors how much money drops out of our bottom line with further fee cuts. And then when they see that big negative number, we’ll ask ‘How do you expect us to generate returns for you?’”
Tensions can arise in relation to differences in compensation between LPs and fund managers, notes the CFO. A public pension employee barely pulling in six figures a year may not be sympathetic to the argument that GPs risk losing top talent if salaries are reduced. And so whether justifiable or not, an open discussion on budget expenses (and thus salary packages) results in some unavoidable frictions between professionals within different income brackets.
The fee debate has been raging for several years, especially since the global financial crisis when LPs started taking a hard look at the cost of their private equity portfolios. Many LPs, like US public pensions, have been working to cut the number of relationships in their portfolios and reduce the amount they pay in fees.
This is unlikely to change any time soon – nor are LPs likely to drop their insistence on getting a better understanding of where their management fees are actually going. So in this fundraising environment, even the biggest-name managers will have to get creative on the fee question.