In the seventh video of our first-time funds series, Marco Pontello and Geoff Kelsall of our Private Equity practice explore essential topics on the management fees and expenses of funds.
They discuss key considerations, including:
how management fees are used and the fee rate during and after investment periods;
organizational expenses borne by investors and a market trend in increasing expense caps; and
typical partnership expenses.
Stay tuned for the next episode of our first-time funds series on distribution waterfalls.
Click here to visit the main First-time Funds Series page.
Geoff Kelsall (00:05): Hi. I'm Geoff Kelsall, a Senior Associate in Torys' Private Equity Group here in Calgary.
Marco Pontello (00:11): And I'm Marco Pontello and Associate in Torys' Private Equity Group in Toronto, and today we'll be discussing the topic of fees and expenses beginning with a discussion of the Management Fee. The Management Fee is used to "keep the lights on", which includes for overhead salaries and other Manager expenses that aren't charged to the fund. The Management Fee is typically a fee percentage multiplied by the fee base. Now, in terms of the fee percentage or fee rate, the range of market Management Fee rates can vary depending on a fund size and strategy. Maybe ten years ago, 2% was the most common fee rate, but now we typically expect a lower 1.25-1.75% fee rate, unless it's a first-time or relatively new Manager. And for these first-time, relatively new Managers, we typically expect a fee rate of 2-2.25%. A flat Management Fee rate for all investors is still the most common approach, though some sponsors might offer alternative Management Fee options, such as differing rates depending on the size of an investor's commitment or lower rates for early closers. Now, the fee base typically depends on whether the fund is in its investment period or after the investment period. During the investment period, in most cases, the Management Fee is based on a percentage of committed capital, whether or not the capital has been contributed.
Geoff Kelsall (01:34): Thanks, Marco. And in the post-investment period, we typically expect Management Fees to be based on contributed capital for investments, meaning dollars that investors have put into the fund that are actually active in an investment. Now, when the post-investment period rate switches to remaining invested capital, realized losses and fully written-off investments are typically deducted from the Management Fee. Now, there's almost always an offset in the Management Fee per transaction and other fees received by the sponsor. Now, typically any fee income received by the sponsor, such as director fees, transaction fees, advisory fees or monitoring fees should offset the Management Fee on a dollar for dollar basis. So every dollar that the sponsor earns in fees from its investments should reduce the Management Fee. Now, if all of those fees have not been offset by reductions in the Management Fee over the life of the fund, then the sponsor is typically required to repay the excess to the limited partners on liquidation of the fund.
Marco Pontello (02:36): Thanks, Geoff. Moving on now to a discussion of organizational expenses and partnership expenses, these are two different buckets of expenses that are paid for by the LPs. Organizational expenses are all of the costs incurred by the sponsor outside of ordinary overhead in actually forming the fund, the other entities within the fund structure, costs associated with structuring the fund, fundraising expenses and marketing, and negotiations with investors. And really the largest costs incurred as organizational expenses, are the costs of the fund's advisors—legal, tax, accounting fees really make up the majority of these expenses. And as mentioned, organizational expenses are borne by the investors, but this is almost always subject to a cap. Caps can be based on a certain dollar amount, so for first-time funds, no more than typically $250,000 incurred as organizational expenses or as a percentage. So the sponsor will not incur organizational expenses in excess of the dollar equivalent of 0.1% of overall commitments to the fund, for example. Now, if the sponsor goes over the cap, they start to incur these costs out of pocket. So it incentivizes keeping costs lower.
Geoff Kelsall (03:52): Thanks, Marco. Now, one unique piece to mention here is that for first-time funds, sponsors are often willing to reimburse the legal fees of the seed investors or anchor investors as an additional incentive for them coming into the fund. So these investors do not end up paying any organizational costs. Now, this is not something that would typically be offered up by a first-time fund, it would more often be a negotiated point brought up by a more sophisticated institutional investor. So we would expect this to be a less common occurrence for a "friends and family" fund. Now moving on to discuss partnership expenses. Partnership expenses or fund expenses are typically borne pro-rata among all the investors. And these essentially include all expenses related to the fund other than any overhead like salaries or rent, which should be borne by the sponsor. Now, in general, partnership expenses include organizational expenses, out-of-pocket expenses incurred by the sponsor and making investments, any other deal-related expenses, and expenses paid to advisors and other consultants in connection with the investment activities of the fund. Now, one important point to note on partnership expenses is that disclosure is very important. So essentially, if an expense is disclosed in a partnership agreement as being something that investors are on the hook for, then this disclosure makes actually charging the expense back to the investors acceptable. This is why we see sponsors take a kitchen sink approach to the list of expenses they disclose in their partnership agreements, meaning essentially pages and pages of disclosure of various expenses that investors could be on the hook for. Now, the practical reality is that this is all disclosure-driven, and many of these expenses may not, in fact, be charged back to investors. What's important from an investor's perspective is being able to understand what expenses they are actually on the hook for.
Marco Pontello (05:53): Right, and another key point that we're seeing right now is LPs focusing on holding sponsors accountable for the expenses that they are charging back. So controversial line-items such as travel and entertainment costs, the cost of maintaining registrations, the costs of research software—these are all items that LPs are focused on right now in ensuring that to the extent they are on the hook for the sponsor incurring these costs, they are kept reasonable. And many institutional LPs are insisting on sponsors having an established expense policy that covers everything from travel, to allocation between funds, in order to ensure that sponsors are treating funds fairly in allocating expenses.
Geoff Kelsall (06:33): Thanks for tuning into our topic today on Management Fees and Expenses. And stay tuned for our next episode on Distribution Waterfalls.
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