Fundraising: Management fees

It’s common practice in the private equity community for LPs to pay management fees on committed capital from the word go, whether or not that capital has been drawn down. But after a quiet few years on the deployment front across the private equity landscape, the question is being raised again as to whether this is really fair on investors.

In June 2015 Terra Firma founder Guy Hands told investors that as well as investing 10 percent of the firm’s own money in each transaction, Terra Firma would no longer be charging management fees on committed capital that had yet to be invested.

“GPs are currently sitting on $1 trillion of un-invested ‘dry powder’, while new deals are at a 13-year low. For this reason, it is not surprising that LPs no longer want to pay high fees on un-invested capital,” Hands told PEI.

However, some industry insiders have suggested that a blanket switch across the industry to paying fees only on money in the ground might in itself throw up conflicts, encouraging GPs to rush into investing capital.

For starters, while large firms with multiple investment vehicles are unlikely to feel the pinch from such a strategy, those at the smaller end of the market rely on the management fee to provide the resources and infrastructure necessary to find great investment opportunities.

One LP PEI talked to pointed out that by their very nature GPs want to be doing deals – and therefore if they’re not, you as an LP need to trust that there’s a very good reason. The added pressure – or incentive – of a management fee tied to investment pace could cloud judgment.

A more nuanced approach such as a graduated management fee might be more effective in ensuring true alignment. Nevertheless, Hands’ move demonstrates a willingness from the GP community to engage and seek solutions on LP concerns regarding management fees and alignment of interest.