US VC management fees on the rise

Limited partners are having to pay higher fees to invest in large, experienced venture funds. How can they protect their interests?

The more experience in venture investing a general partner has, and the larger the funds it manages, the higher the fee investors will be expected to pay to participate, according to a newsletter written by Harvard Business School professors Paul Gompers and Josh Lerner and published in association with Salomon Smith Barney.

The study confirms that fees charged by US buy-out funds and non-US private equity operators decline with fund size. Small funds with up to $50m under management charge nearly 2.4 per cent of committed capital, a number which reduces with fund size to 1.9 per cent for non-US funds, and 1.6 per cent for US buy-out funds respectively.

The study reveals however that venture capital funds do not follow this pattern, asking investors in the largest funds instead to pay the highest fees. Smaller VC funds charge 2.3 per cent on average and gradually work their way up as their size increases, the researchers say.

Entitled General partner compensation: Are general and limited partners aligned?, the report also notes that an increasingly high premium is being attached to a partnership’s track record of investing in private equity deals.

According to the research data, for funds raised up until 1992, more experienced GPs charged lower fees than relative newcomers. In 1993 the trend reversed, with established GPs beginning to ask for substantially higher fees than less experienced competitors.

The findings suggest that investors today are willing to pay a premium for access to the largest, most successful venture capital managers whose costs have also risen steadily over the past decade. Gompers and Lerner argue that the increase in management fees is directly related to the growing sophistication and efficiency of venture investing.

Greater competition for investment opportunities and staff, rising compensation expenses and a “flurry of experimentation” applied to venture capital investment strategies are among the factors cited by the report which drive up both expenses and fees charged by leading firms.

The trend can be likened to developments in US investment banking during the 1950s and 1960s when market leading institutions undertook huge efforts to solidify their market positions.

The findings are part of broader – and increasingly topical – discussion on whether higher levels of compensation of private equity managers can be justified.

Management fees are one of two elements of GP compensation, carried interest as a percentage of a partnership’s profits being the other. Carried interest is the main mechanism used to ensure GPs are sufficiently incentivised to maximise returns to their investors.

Finding the “right” balance between fees and carried interest to reconcile GP’s and LP’s respective interests is obviously a key issue in negotiations between private equity firms and their investors. The arguments are complex, and the bottom line depends on how well a fund is ultimately performing.

Gompers and Lerner argue that examining “the trade-offs associated with different levels of management fees and carried interest” shows that “at low levels of investment returns the limited partner is better off letting the general partner have a higher carried interest in exchange for a lower management fee.” Conversely LPs see more of the upside but shoulder more of the downside when they pay their GP a high fee but less carried interest.

If higher fees are essential for GPs to stay competitive, and carried interest is needed for motivational purposes, how can limited partners protect themselves against poor performance? The Harvard scholars argue that not enough attention is being paid to alternative compensation structures that make the level of paid carried interest a function of investment performance. The return of negotiated budgets, a more common arrangement in the past, could also offer possibilities.

This debate is certain to continue for the foreseeable future. The outcome is far from clear, although one thing is for sure: the one way for general partners to enhance their future bargaining power is to outperform the market now. Track record will always get you a long way.