The traditional private equity-birthed model for management fees does not align interests for limited partners (LPs) and general partners (GPs) for emerging market venture capital and early-growth PE funds that are under $100 million.
As a global emerging market fund investor, we evaluate more than 200 VC/PE fund proposals per year across Africa, Latin America, and South and Southeast Asia. We also talk every week with multiple fund investors (most call themselves LPs) to get their feedback on funds that they are seeing and evaluating.
The fees tug of war
One of the most focussed on and hotly discussed topics is fees. Fund managers (most call themselves GPs) are “defending” their need for the proposed management fees in order to have sufficient resources to professionally manage their investing strategy, with the largest item being the principals’ and staff’s compensation expenses and profit-sharing fees that give them upside if they can deliver profits (aka “carry”).
The LPs are trying to understand why the GPs need to pay themselves such large salaries and question if there is sufficient “skin in the game” from the GP principals to align interests in the long term. The LPs’ concern is that GPs can be paid handsomely, or maybe even excessively, via management fees even if the GPs invest their money poorly and don’t deliver expected returns.
The default ask by GPs in under $100 million funds is “2 and 20” – 2% per year as management fees and 20% of carry. These two items are generally the core “fee package”. I have previously shared about a better way to align LP/GP interests on carry, so here I’m going to focus on the management fee component.
I approach the management fee conversation from a different angle.
As a fund investor, I often ask the GP the following questions:
• What is the smallest annual operating budget you need to do a quality job of managing this fund? And what is your preferred budget? Explain both scenarios with trade-offs.
• You are proposing to increase your firm’s annual operating budget by 200% (or whatever it is) with additional fees generated by this new fund. Where will you be spending the incremental fees?
Why do I ask these type of questions? Because I really don’t care about what percent management fee they are asking for. What I care about is what size of operating budget they need and the logic behind that.
For example, how much is going to hire new staff, compensate current staff more, move into a fancy new office, upgrading to business class travel, paying for overpriced attorneys, and … drum roll please … going to pay principals.
What is the most common answer? Poor quality “hand waving” type answers.
A remarkable number of managers, even experienced ones, have not really thought through how to address such a straightforward question. And they generally won’t admit it. They haven’t done the work to research and prepare a bottoms-up budget forecast. They just assume it is okay to ask for 2% or even 2.5% “because doing business is expensive in this place.”
I think to myself, would they invest in a startup business where the CEO hadn’t done their homework on revenue forecasts and operating budgets? See my other post on why fund managers need to be entrepreneurs as well.
So, I send them back to prep a bottoms-up operating budget forecast for the “minimal” and “preferred” scenarios and ask them to send to me before our next call.
Most LPs focus on incentivizing capital deployment beyond the investment period.
In the 2% management fee scenario, most old-school LPs are “okay” with the basis of the 2% fee to be “committed capital” during the investment period (usually three to five years for VC funds). Then LPs want the basis of the management fee to shift to something like “net invested assets” – that is, the amount that has been deployed to investee companies. (This is generally the cost basis of investments made by the fund, less the proportion of shares sold. So, if the fund invested $1 million in a company, the value would initially be $1 million. If the fund sold 50% of its shares in that company, then the value would be reduced to $500,000.)
The thinking is that this will motivate the GP to quickly deploy reserves which is somehow correlated to speeding up when they will be able to exit the investments. They also prefer to not pay management fees on management fees and fund expenses. (If you have a $50 million fund and the forecast is for $10 million in fees and expenses over the 10-year duration of the fund, then the fund’s investable capital is $40 million. When you pay management fees based on committed capital, you are paying it on the full $50 million.)
The problem with this approach is that this results in a dramatic cliff on fees right after the investment period ends. For instance, VC funds often initially invest smaller amounts in many companies and then hold substantive reserves to double and triple down on the best companies that emerge.
So, it is not uncommon at the end of the investment period for the fund to have deployed only 40-50% of the committed capital. This would mean a 50% drop in management fees right after the investment period.
Then it gets even more complicated.
Often, the discussion turns to the basis post investment period to being “net invested assets plus something else”. Often the something else is some quantity of reserves, but then this gets really complicated to define.
Here are the problems with this approach to post investment period management fees thinking:
• The GP is incentivized to increase net invested assets as soon as possible at or after the investment period whether this makes sense or not in order to earn higher management fees;
• The GP is incentivized to hold on to investments longer and write them down/off more slowly because that would reduce management fees post investment period;
• The GP will need to start fundraising for a successor fund earlier to reduce the period of lower management fees after the investment period – paying less attention to their current fund and its performance; and
• GPs are (understandably) going to ask for a higher management fee during the investment period due to the unpredictability of fees post investment period.
But the biggest problem with this typical approach is that it creates unpredictable management fees for both the GP and the LP. The net is that this is an over-engineered fee structure with a lot of perverse incentives that misalign the LP and GP interests.
So, predictable “budgeted” management fees is a better solution.
I believe there is a simpler and much more aligned approach to setting management fees – a pre-defined management fee budget for the entire fund duration. This approach defines a year-by-year budget which recognises that there is some additional heavier lifting in the early years as the portfolio is being selected and then a predictable, graduated budget in the outer years.
This enables the GP is focus on maximising the fund’s results without having to think about how their buy/sell decisions are impacting their operating revenue, nor does it incentivize the GP to pre-maturely raise another fund.
Example: For a $50 million fund, the agreed budget might be $1.25 million for the first two years and $1 million for the next two years of the investment period. Then reducing to $850,000 in years five and six, $700,000 in years seven and eight, etc. (Of course, you could convert this back into a percent of committed capital for each year.)
The discussion then can focus on what the right budget is based on the investment strategy. And you could even decide to have checkpoints along the way managed by the fund’s advisory council (often called LPAC, with members from the fund’s largest investors) to review the budget needs and have some authority to increase or decrease modestly. But be careful about making it too easy to change the budget as this could create unintended misalignment.
Dave Richards is the co-founder and managing partner at early-stage fund-of-funds Capria.
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