Management fee math and fee offsets

Key takeaways

• Management fees are usually charged on committed capital during the investment period and then on invested capital (or occasionally NAV), often with a lower rate after a step-down.
• Under the example terms (2.0% on commitments for five years, then 1.5% on net invested capital) Fund M charges $68.9m of fees over ten years, 13.78% of its $500m commitments.
• A 100% offset credits every dollar of transaction and monitoring fees against the management fee; at 80%, the GP keeps a fifth of those fees, which in the example is $3.2m over the fund life.
• When offsets exceed the fee due in a period, the LPA decides whether the excess carries forward, is refunded or is lost, and the difference can be material late in a fund's life.
• Organizational expense caps limit the formation costs charged to the fund; costs above the cap are borne by the GP, often through a reduction of the management fee.
• Fixed-dollar costs weigh more on small funds: with identical fee terms and a 2.0x gross multiple on invested capital, a $100m example fund nets 1.50x against 1.57x for a $1,000m fund.

What the management fee is for

The management fee is paid by the fund to the GP or its management company to cover the cost of running the firm: salaries of the investment team, offices, travel, sourcing, research and the firm's own overhead. It is not meant to be a source of profit in itself. The GP's reward for performance is carried interest; the fee is meant to keep the lights on while that reward is earned.

The fee is set out in the LPA as a rate and a base, usually expressed per year and charged quarterly or semi-annually in advance. It is funded through capital calls, so it is part of each LP's paid-in capital, and it reduces NAV relative to paid-in capital from the start of the fund, which is one cause of the early dip in the J-curve.

In practice the fee often funds more than a lean budget, especially in large funds where fixed costs are spread over a large commitment base. That is why LPs negotiate the base, the step-down and the offsets, and why the ILPA Principles call for fees to be tied to the reasonable cost of running the fund.

The fee basis

During the investment period, when the GP is building the portfolio, the most common base is committed capital. The fee is therefore the same in year 1, when little has been invested, as in year 5. The argument for it is that the GP's workload in sourcing and diligence does not depend on how much has already been deployed. The cost to the LP is that it pays full fees on capital that is still unfunded.

After the investment period, the base usually switches to invested capital: the cost of investments still held, often called net invested capital because realized investments drop out and, in many LPAs, investments that have been written off or permanently written down drop out too. As the portfolio is sold down, the base shrinks and so does the fee. Some funds use NAV instead, which ties the fee to reported value; that can reward markups and gives the GP a mild incentive not to mark down, so LPs tend to scrutinize it.

A smaller group of funds charges on invested capital from the start. That removes the drag of fees on unfunded commitments but can reward fast deployment. None of these bases is universal, and the definitions of 'invested capital' in particular differ from one LPA to the next.

Step-downs

A step-down is a scheduled reduction in the fee after a trigger. The trigger is usually the end of the investment period, but it can also be the earlier of that date and the first close of a successor fund, since once the GP is earning fees on a new fund, the old fund's LPs should not keep paying for new deal sourcing. The step-down can be a change of base, a lower rate, or both.

The distinction matters more than it looks. A rate cut on an unchanged commitment base is worth far less to the LPs than a switch to net invested capital, because the invested base shrinks every time a company is sold. The worked example below compares three structures on the same $500m fund.

A ten-year fee schedule for Fund M

Fund M is a hypothetical $500m buyout fund with structure C: 2.0 percent a year on commitments during a five-year investment period, then 1.5 percent a year on net invested capital. Fees are shown annually for clarity; in practice they would be charged in quarterly installments. The schedule below also shows the GP's receipts of transaction and monitoring fees from portfolio companies, which the next section offsets.

Two figures are worth taking from the schedule. First, 72.6 percent of all fees ($50.0m of $68.9m) are paid in the first five years, when most of the value creation has yet to happen. Second, an LP with a $25m commitment, 5 percent of the fund, pays $3.445m of fees before offsets over the fund's life.

Transaction and monitoring fee offsets

Many GPs charge fees directly to the companies their funds own: transaction fees when a deal closes, monitoring or advisory fees each year while it is held, director fees for board seats, and sometimes break-up fees when a deal falls through. The fund owns those companies, so every dollar of such fees is a dollar taken out of an asset the LPs own. Without an offset, the GP is paid twice for the same work: once through the management fee and again through the portfolio fees.

A fee offset credits some percentage of those portfolio fees against the management fee the LPs owe. At 100 percent, every dollar the GP receives reduces the management fee by a dollar, so the GP gains nothing from charging portfolio fees. At 80 percent, the GP keeps 20 cents of each dollar. Many LPs negotiate for a 100 percent offset, lower percentages still appear, and the definition of which fees are covered varies from one LPA to the next.

When offsets exceed the fee

Late in a fund's life, when the fee base has shrunk, a large transaction or exit-related fee can produce an offset bigger than the fee due. The LPA then decides what happens to the excess. The LP-favorable answer is that it carries forward against future fees and, if it cannot be used before the fund ends, is refunded to the fund. The GP-favorable answer is that the excess is simply lost, meaning the GP keeps it.

The question also arises across funds: a GP with several funds may receive fees from a company owned by more than one of them, and the offset should be allocated in proportion to each fund's ownership.

Organizational expenses and caps

Organizational expenses are the costs of forming the fund: legal fees for the LPA and side letters, regulatory filings, and similar setup costs. Most LPAs charge them to the fund, so the LPs bear them pro rata, but cap the amount. Costs above the cap are borne by the GP, commonly by reducing the management fee dollar for dollar. Placement agent fees are commonly borne by the GP, either directly or by a full offset against the management fee.

Ongoing fund expenses are separate from both the management fee and organizational expenses: audit, fund administration, tax preparation, legal work on fund matters, insurance and sometimes costs of broken deals. They are usually not capped, which is why the list of expenses the LPA allows to be charged to the fund deserves as much attention as the fee rate. The ILPA Reporting Template separates these categories so LPs can see them.

Why fee drag hurts small funds more

A fund's costs are part variable and part fixed. The management fee is a percentage, so it scales with the fund. Many fund expenses do not: an audit, an administrator's minimum charge, tax work and legal compliance cost broadly similar dollar amounts whether the fund is $100m or $1,000m. Spread over a smaller commitment base, those fixed costs take a larger share. A small GP may also need a higher fee rate simply to pay a minimum viable team.

The effect compounds into net returns because every dollar of fees and expenses is a dollar not invested. The example below holds the gross multiple on invested capital constant at 2.0x and uses a simplified carry of 20 percent of total profit (hurdle cleared and catch-up complete), so the only differences come from the cost structure.