Getting Rich Off Management Fees?

One of the most frequent comments I hear from LPs when discussing private funds is some variation of, “The GPs are getting rich on management fees.”  

Most investors know the headline numbers. Market standards are usually a 2% management fee and a 20% carried interest allocation, or “2 and 20” in LP speak.  

What does this mean, though? Let’s start with a simple point: management fees are not investment profits; in fact, they are likely not profits at all for the GP. The real question investors should ask is whether the fees are sufficient to build and maintain the organization necessary to execute the strategy you’ve invested in. As investment managers, our due diligence work on prospective funds is focused on people & process first, then philosophy and analyzing the output that is performance. We place a high priority on the people, and with that, the organisational structure. Assessing how the firm is being built and resourced, and if that fee budget is necessary for the fund to generate the alpha we seek, is critical to our investment process.

A 2% fee on a $50 million fund produces quite different organizations versus a 2% fee on a $500 million fund. The question to ask here is what the fee actually supports. What capabilities does it enable? Does this fee level provide the manager with the resources necessary to execute their stated strategy, the one you’ve spent months underwriting?

Regardless of the size, the dynamics are the same. A GP invests LP capital in the early years of the fund without knowing the total return on that activity for 7-10 years. During that period, the GP has to build and operate the organisation responsible for sourcing investments, conducting diligence, supporting portfolio companies, communicating with LPs, and handling all the countless responsibilities that come with managing a fund.  

That’s what management fees provide to the fund. They are used to hire and pay capable investment professionals and operating personnel, as well as all of the infrastructure required to run a business, things like benefits, software, research tools, travel, recruiting, investor relations and compliance. In a very real sense, LPs are providing the working capital that allows the GP to pursue the returns they are expecting over time.  

Management fees are not the prize. These are the cost of doing business. The real prize in this industry is carried interest, the uncapped upside participation in gains on successful investments. However, before the GP participates in a dollar of carried interest, the LPs must first receive back their invested capital.  

That’s not just the dollars that were invested into portfolio companies, but the entire capital commitment that funded the fund’s activities along the way, including management fees and fund expenses. Think about every dollar of management fees taken as a draw against the GP’s participation in future gains.

LPs can think of their management fees as a loan to the GP. The GP gets to build the organisation they believe they need to execute the strategy. Because of that, the LP gets first claim on getting their invested capital back. In most waterfalls, that means all of it, including the fees and expenses. LPs are made whole before the GP can share in the upside. Simply put, the GP needs to pay back the management fees before he can share in the prize.

Here is a simple example:

Fund A raises $100 million and returns exactly $200 million. In this case, it takes five years before the LPs have received their $100 million investment back, which includes all of the fees and expenses, which have been repaid from investment returns. The GP has been paid $1 million in fees at year five to fund his business. He now can share in the profits, but he still has to net off fees and expenses. From year 5 to 10, the GP will earn $20 million approximately from the returns. Averaging this out over time, let’s call it $22 million over 10 years or $2.2 million per year to make these investments. It’s important to remember that this compensation is largely paid to the GP on the back end, with no assurance that he will make anything, a risk shared by investors.

That’s why I think the statement of ‘GPs getting rich on fees’ is overstated. You shouldn’t look at management fees as high or low in isolation. It comes back to the original premise of whether the fee budget is sufficient to build and maintain the organization necessary to execute the strategy you’ve invested in.

At the end of the day, LPs need to remember that fees and expenses are essential parts of a fund’s economics, but particularly at the smaller end, it’s never the prize, it’s the means to the real pot of gold at the end of the rainbow, the sharing in the profits, creating a win-win for everyone involved.  

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This article was written by Matt Curtolo, Managing Director, Investments, and Gavin Ezekowitz, Co-Founder and Chief Investment Officer.