Top funds feel the pressure on management fees

Recent data from Paul Weiss show the average headline fee rate has dipped below 2%.

Even fund managers in the upper echelons of the industry are feeling downward pressure on management fees, new research reveals.

A survey put together by Marco Masotti, who leads the private funds group at law firm Paul Weiss, and his team has found that the headline management fee rate for most private equity funds is now in the range of 1.5 percent to 1.75 percent per year. This is before blended fee rates or other discounts are taken into account.

As these firms are raising ever-larger funds, Masotti points out that the dollar amount of management fees is likely unaffected.

“They may feel a little bit of pressure on the rate, but it’s not that they’re getting less in terms of management fees,” he told Private Equity International.

Masotti pulled the data for the survey from the fund agreements of more than 35 recent private equity funds with a minimum target fundraise of $3 billion, including “only the most established and well-known” funds and fund managers.

While the most sought-after funds have the luxury of over-demand – and therefore can set more aggressive fund terms – most managers are taking a longer-term approach.

“It’s a marketplace of relationships. A lot of these firms are building diversified businesses, and these LP relationships are the asset of the business. It’s not just about one fund,” Masotti said. “They want healthy and robust investor relations, so if there are things that are sensible, the GPs are willing to agree to it.”

Here are five other takeaways from Masotti’s research:

  1. The ‘early bird’ discount is unpopular

Just 17 percent of funds offer an “early bird” discount to LPs who commit to the fund at the first closing or early in the offering. According to the survey, these discounts often apply only to management fees paid during the commitment period.

However, a growing number of funds are providing a discount based upon size of the capital commitment. Around one-third of funds surveyed are offering tiered management fee structures based on capital commitment size.

“In reality, the percentage of private equity funds providing size-based discounts with respect to management fees is probably higher, as breaks in economic terms are frequently reflected in side letters, rather than in the express terms of the fund documents,” the survey notes.

  1. Nearly all distribute carry on a deal-by-deal basis 

The vast majority – 91 percent – of funds distribute carry on a deal-by-deal basis. However, the survey notes that LPs are increasingly demanding – in line with the ILPA Private Equity Principles – to alter the model by returning all expenses paid to date (rather than an allocable portion), known as “modified deal-by-deal”, and to use carry escrow accounts as security for any clawback obligation. Around a quarter of funds are using such accounts.

While escrow accounts are not a necessity for large managers with big balance sheets, for some firms they can make a tough clawback situation much easier to manage.

“These are long-dated products, and people leave. It’s very hard to deal with a clawback situation when it actually happens,” Masotti said.

  1. The 8% pref is holding steady – for now

The historical 8 percent preferred return on contributed capital is still the most popular, with 76 percent of funds setting their hurdle at this rate. However, the survey notes an “increasing number” have a lower preferred return, and 15 percent have no hurdle rate at all.

“There is some appreciation in the marketplace that the ticking clock of the hurdle rate could factor into the timing of investment decisions, creating an inadvertent misalignment of interests,” Masotti notes in the survey, adding that some GPs will actively assess whether “meaningful economic alignment of interests” can be achieved in other ways instead, such as through a “net asset value” test.

  1. GPs are backing themselves to deliver

GPs in this pool have strong conviction in their offerings, as demonstrated by the chunky GP commitments they’re making to their own funds. More than three-quarters are committing more than 3 percent of the aggregate commitments to their funds, with 26 percent committing above 6 percent.

  1. Half of subscription lines have a 12-month term

Twelve-month subscription lines of credit are by far the most popular, with 50 percent of funds limiting the time during which a borrowing may be outstanding to this length. Around 75 percent of funds surveyed limit borrowings and guarantees to between 15 percent and 30 percent of the fund’s commitments, with 13 percent borrowing up to 50 percent.