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Vanilla or chocolate: doing the maths on fund fees

A higher carried interest ensures a better alignment between a GP and its LPs even if LPs end up paying more in fees.

At the beginning of the month we wrote in a commentary –Vanilla or chocolate? How do you like your fund terms? –that it still pays for GPs to give LPs options on terms as funds like Bain Capital Fund XII, which recently closed on $9.4 billion, have done.

The Bain fund, like its predecessor, offers two options for fees, with Class A shares having a 1.5 percent management fee and 20 percent carried interest and Class B Shares having a lower 0.75 percent management fee but a higher 30 percent carried interest.

While offering flexibility helps attracting a wider net of investors, we were curious to calculate at what point option A, assuming the above fee structure of Class A shares, is more attractive for LPs than option B, which assumes the fee structure of Class B shares, and at what point does it cease to be the case.

With the help of an anonymous analyst at a large private equity firm, who assumed an 8 percent hurdle rate and a 50 percent catch up rate, we found that LPs would pay lower fees under option A – but only up to a certain point.

As the chart below shows, in the early days of our hypothetical fund, investors pay no carry and the management fee is higher under option A. That remains the case until the fund hits a 15.8 percent return, at which point, Class B investors pay more in fees as the carry kicks in.

As we mentioned last week in our commentary, option B provides greater alignment between GPs and LPs and creates a stronger incentive for GP to perform.

“If it were my money I would always take the lower management fee,” one fund formation lawyer said. “The higher management fee is a fixed cost regardless of performance. All returns should come from the carry, and the management fee shouldn’t be a profit center on its own. But it has to be the right preferred return.”