LP Corner: Fund Terms - Management Fee

This is one of a series of posts on fund terms.  Other posts include:

• ​GP Commitment
• Carried Interest Overview
• Carried Interest – Preferred Return and GP Catchup
• GP Clawback
• Management Fee Offsets
• Key Person Clauses
• No Fault Divorce
• For Cause Actions
• Should Venture Capital Funds have a Preferred Return Hurdle?

In private equity, the term “2 and 20” refers to the traditional compensation structure for private equity funds: 2% management fee and 20% performance fee (also known as “carried interest” or “carry”).
 
In this post, we will explore management fee.
 
Historically, management fee was intended to provide fund managers with enough money to pay modest salaries, rent modest offices and incur modest expenses.  It was said that management fee was intended to let the fund manager “keep the lights on” and that the performance fee (known as “carried interest” or “carry”) was where the fund manager made its money.  While investors in private equity funds (known as “limited partners” or “LPs”) continue to take this view, terms in fund documents (known as the "limited partnership agreement" or "LPA") relating to management fee have become more complex.
 
Let’s dig in.
 
In previous posts, we have explored committed capital and the investment period:

• LP Corner: On Committed Capital, Called Capital and Uncalled Capital
• LP Corner: the Four Phases in the Life of a Private Equity Fund
• LP Corner: Private Equity Cash Flows from the LP Perspective

 
We will look at management fee in three phases of a fund’s life: the investment period, the harvesting (or realization) period and during extensions.

To read more, please click on the "Read More" link below and to the right.

Investment period
The vast majority of private equity funds (here, we’re discussing buyout, growth equity and venture capital funds) charge 2% of committed capital per year during the investment period, which has traditionally been 3-5 years, but I’m seeing this extend to 6 years.  For example, a $200 million fund with a 2% management fee will provide the manager of the fund (also known as the “general partner” or “GP”) with $4 million per year.  Management fee is always paid quarterly in advance.  In our example, this means that the fund will pay the GP $1 million in management fee per quarter, at the beginning of the quarter.  This management fee pays for the salaries of the investment team, office staff, office rent, utilities, etc.  Part of the rationale for this fee is that during the investment period, the GP is going to be very busy sourcing and evaluating deals and making investments.
 
Harvesting (realization) period
After the investment period, the fund will no longer invest in new companies, but will continue to support and invest in existing portfolio companies.  Also, the GP will have likely raised a new fund, which will also be generating management fee.  During the harvesting period, management fee will generally decline, and there are many different ways management fee is determined during this harvesting period.  Often, the management fee will stay at 2%, but the base is changed from committed capital to invested capital.  Other times, the management fee will decline by some percent each year, so that in the first year after the investment period the fee drops to 1.75%, the next year 1.5%, the next year 1.25%, etc., with some floor, such as 1% of committed capital.  There are many different permutations of management fee during the harvesting period.
 
Extension period
Private equity funds are usually 10 year funds, but the GP often has the right to unilaterally extend the term of the fund by one or two years.  This is referred to as a “10-year term with two 1-year extensions.”  Usually, during the two GP-option extensions, the formula for management fee in the harvesting period continues.  It is when funds still have active investments at the end of 12 years, does management fee become a further issue. 
 
To extend a fund’s life after the 10 year term and the two 1-year GP extensions, the GP will usually need to obtain the approval of the limited partner advisory committee or of a majority-in-interest of the limited partners (see the Glossary for an explanation of this term).  Now that the GP needs the approval of the LPs to extend the term, the LPs will negotiate the management fee for this additional extension period.  Many LPs take the hard-line position that the GP should not receive any management fee during these additional extensions, and will vote against any extension to force the fund into liquidation.  Others will negotiate with the GP on a management fee based on the remaining portfolio.  Often this is a very reduced management fee, such as 1.25% of the lower of cost of the remaining investments or their fair value.  The management fee can also be based on a budget or some other basis.
 
Additional Notes:

• Smaller Fund Management Fee.  Some smaller funds ($100 million in committed capital and under) may charge a higher management fee of 2.25% or 2.5%, and larger funds (over $1 billion in committed capital and over) will charge lower fees, usually around 1.2% to 1.5%.
• Large Fund Management Fee.  Some large funds are now offering fee and carry options for LPs, such as a choice between a 2% management fee and 20% carry or a 1% management fee and 30% carry.  Some LPs prefer the latter (10%/30%) option as they feel it better aligns the interests of the GP and the LPs.
• Fee on Called Capital Only.  A few funds have offered management fee only on called capital.  This is very appealing to LPs as it means the LP pays fees only when the GP is putting the money to work.  This has happened in only a few unique circumstances, such as in a follow-on fund (a fund raised to support the investments of an earlier fund that has called most or all of its capital).
• Breaks.  Some funds offer one-off management fee breaks for “first closing” investors that invest a certain minimum amount.  This is meant to incentivize investors to invest early, at the first closing.  It’s a tool to build momentum for fundraising.  For example, an investor who commits $20 million to the fund in the first closing may pay a reduced 1% management fee for the first year of the fund.
• Successor fund.  It is customary for GPs to raise successor funds prior to the end of the investment period.  Many LPAs provide that when this occurs and the GP starts to receive management fee from the successor fund, the management fee for the current fund will start stepping-down.  
• Expenses.  What expenses are paid by the fund and what expenses are paid by the GP are often heavily negotiated terms.  Issues such as travel, compliance, administration and other items are negotiated as part of the limited partnership agreement.
• Fund-of-Fund Management Fee.  Funds-of-funds fees are usually around 0.75% to 1.00% of committed capital.  Funds-of-funds fees have been under a lot of pressure over the last several years.