Private equity fees require dynamic due diligence: An examination of private equity fees and expenses
As a category, private equity funds are known to have some of the highest and most complex fee structures in the investment world. Their complexity is magnified by the distribution mechanics within private equity funds that specify the order and amount of fees to be charged and returned to the various parties during the life of the agreement.
While the relative level of fees charged on a percentage basis has declined over the last several decades, the absolute level has increased dramatically driven by the significant increase in fund sizes. As a result, we have increased our focus on fees and expenses, particularly given the importance of transparency for investors and the greater scrutiny surrounding the Securities and Exchange Commission’s (“SEC”) investigations over the past 18 to 24 months.
The main categories of fees and expenses we examine during our due diligence efforts are management fees, carried interest, preferred return, organizational expenses, transaction fees and fee offset provisions. For the purposes of this article, we are excluding the carried interest and preferred return provisions and focusing on the other categories as these tend to have greater variability and have attracted more attention from the SEC of late.
The most common fees seen in private equity fund agreements are management fees. They are usually structured as a percentage of an investor’s commitment to the fund during the investment period (ranging from 1% to 2%) declining to a lower percentage of remaining invested capital thereafter depending on the fund’s specific strategy. The original concept behind management fees was to cover the manager’s ongoing staffing and overhead costs while it sources, screens and executes investments and was not intended to be a profit center. However, as fund sizes increased over the last several decades, management fee income has grown significantly and now generates substantial profits for larger firms.
In evaluating the reasonableness of the management fees, investors should consider the size of the manager in terms of the number and size of prior funds, whether prior vehicles are generating fees and the number of professionals and offices.
Investors also should consider projected growth of the team. Compensation is typically the single largest use of management fees and is a key driver of behavior for the manager’s investment professionals. Thus, it is important for investors to understand all sources of compensation across the team and how this drives incentives for the investment professionals.
In order to best assess the reasonableness of the management fees being charged, whether the fees cover reasonable operating expenses and salaries, and appropriately take into account the lower levels of incremental expenses associated with the formation of a follow-on fund, investors should request a three-year operating budget from managers. We note that, while we regularly make this request, very few firms are willing to disclose their operating budgets. For those that do not, the request may then drive a detailed discussion that generates enough information on which to make an assessment.
Additionally, in certain situations, managers may offer more than one management fee/carried interest combination. In order to determine which option works best, investors must assess the fund’s expected return characteristics and overlay their own specific preferences regarding fees and cash flow patterns.
We have found generally that for most high performing managers, choosing the option that results in a higher management fee/lower carried interest (profit sharing) component generates the optimal long-term return for the client.