Formulae: Investment fees are annual charges assessed by a GP of a private equity partnership to provide it with the financial resources to pay for its day-to-day operating costs. These costs include current compensation of employees, office rent, travel and entertainment expenses unrelated to specific deals, and other forms of overhead. In UK limited partnerships, for tax reasons, these fees are usually described as' priority profit shares'. Such fees are assessed annually and are usually in the order of 1.5 percent to 2 percent of the committed capital of the partnership during the investing or 'primary' period (that is, the first five years of the partnership's normally ten-year fixed life). During the investment period, the GP incurs costs in generating a flow of potential investments, assessing and doing due diligence on them, negotiating their debt financing, and ultimately deciding whether they merit a place in the partnership's portfolio and therefore require use of the partnership's committed capital to fully finance their purchase via an equity investment.
Step-Down in Fees During the Secondary Period
After the end of the investment period, when the partnership enters its 'secondary period' (usually also five years in length), typically investment fees 'step down' to approximately one-half to three-quarters of the rate of the investment fee assessed during the primary period. The degree of step-down can vary quite a lot, as perhaps surprisingly, LPs seem to concentrate less on secondary period fees in reviewing partnership documents, even in the post-GFC world. The rate steps down for two reasons: first, it is presumed that the cost of monitoring an investment is less than that of finding, evaluating, and negotiating the purchase of a new one and, second, most GPs -by the time the secondary period has started on an existing partnership - will have succeeded in raising a successor partnership, which will provide a fresh income stream from its own investment fees. During the secondary period, investment fees usually move to a range of 0.75 percent to 1.25 percent of the remaining cost of investments, that is, the amount of capital originally committed from the partnership to investments in total, less the capital devoted to investments now sold and any write-offs of capital invested in poorly performing investments, where it has been partially or wholly lost.
Investment Fees as a Long-Term Loan
Importantly, investment fees are drawn from the capital originally committed to a partnership, and are not an extra expense borne by LPs over and above their individual commitment. As such, since the GP is required to return to investors the capital committed to a partnership, plus a preferred return (effectively interest on drawn capital commitments - see below for fuller explanation), before receiving any profit interest as manager of the partnership's portfolio of investments (or carried interest - again, see below), then effectively the investment fees the GP receives from LPs are a long-term, unsecured loan from the partnership and its investors. Repayment obligations are secured by the assets of the partnership as they are put in place, but are non-recourse to the GP.
Balancing Operational Costs and Investment Returns
Simply put, even though investment fees may be a sunk cost from the GP's perspective (in that they are expended on salaries and overhead and cannot be recovered), nonetheless they must be repaid to LPs - plus interest - before the GP receives any profit from the partnership. Investment fees normally accumulate to about 8 percent to 10 percent of a partnership's committed capital at their peak, before the partnership starts to generate positive income flows from exited investments to repay LPs' committed capital. On this basis, GPs have to budget both their own multi-year plans for operating expenses and their assumptions for the amount of capital they can commit to investments. In proverbial terms, they cannot afford to run out of money to keep the lights at the office on, yet at the same time need to assume they do sufficiently good deals that the 90 percent or so of a partnership's capital put to work in investments will generate gains of at least 100 percent of the partnership's capital plus accrued interest for as long as that capital (whether spent on investment fees or investments) is outstanding - or else they will receive no profit from their years of hard work in finding, managing, and exiting the partnership's investments.
Post-GFC Pressure on Fee Structures
In the post-GFC environment, LPs have exerted pressure to reduce fee levels in a variety of ways, especially for larger partnerships where the gap between the scale of fee streams and actual running costs has arguably been the widest among private equity companies. It is now typical, for example, for GPs of such partnerships to offer 'early bird discounts' to reward investors committing to first closings on partnerships, thereby giving the fundraising credibility and momentum in the market. These discounts are usually sufficient to bring investment fees down from the customary 1.5 percent level to 1.3 percent to 1.4 percent, representing a discount of up to 15 percent. Investors making particularly large commitments can also reduce these levels further through private negotiations beyond the generic early bird discount or can sometimes structure separate vehicles with special, reduced terms that invest in parallel with the main partnership.
The Rise of Co-Investments
Finally, LPs in recent years have become far more focused on making co-investments in a GP's individual deals, boosting their exposure beyond their pro rata share in the deal secured via their fund commitment. Co-investments are usually free of investment fees and carried interest and so can be highly attractive to LPs in reducing their investment management costs relative to assets deployed.
Evolution of Fee Structures in Private Equity
Nuances: From the outset of the private equity industry in the 1970s, the standard fee on a private equity fund has been 2 percent of capital commitments, paid annually. As private equity fund sizes increased, often at a pace faster than the expansion of firms managing them (and the associated operating expenses), investors insisted on a reduction in the annual fee rate charged to a headline rate of 1.5 percent or so on larger funds (and now, in practice, even less after discounts). Rightly, investors are keen that investment fees do not become so significant in scale for a GP that its team may earn substantial rewards from current compensation, potentially leaving it less motivated to generate long-term investment gains and partnership profits. As LPs and GPs share partnership profits, their financial interests in earning them are aligned in a manner that the respective payment and receipt of investment fees are not.
More Precise Fee Calculations
In addition, as the precision of private equity fund documentation has improved over time, other narrower and more technical fee-related formulas have also tightened. For instance, the step-down in investment fee rate often takes effect when a predecessor fund is 85 percent invested, instead of the previously accepted 100 percent. This is based on the presumption that when allowing for reserves in the predecessor fund for additional fees and add-on investments, this is the juncture where a successor fund (charging a full rate of investment fees) starts to receive a GP's new investment opportunities. The GP then starts using the new fund as its primary source of capital for investments.
Refining the Definition of Committed Capital
Furthermore, the definition of the remaining base of committed capital used to compute stepped-down investment fees during the secondary period has become more exact. This might not only account for carve-outs from committed capital for written-off investments but also for written-down ones. There's no differentiation between investments that are completely lost and those which have diminished in value but are still being managed by the GP, who is trying to recoup some value.
The Changing Landscape of Transaction Fees
Lastly, and perhaps most controversially, investment fees can be influenced by the transaction fees GPs charge on finalized deals. Before the Global Financial Crisis (GFC), it was standard for GPs to receive, in addition to regular investment fees, extra 'deal' fees upon the closing of a new investment and compensation for sitting on boards and monitoring investee companies during their tenure as a fund asset. Collectively, these deal and monitoring fees (which can greatly vary) were referred to as transaction fees. In the past, these fees were not shared with LPs and thus were a significant additional revenue stream for the GP. However, over time, LPs negotiated rights to these fees, which manifested as offsets or credits against investment fees.
The Shift Towards Transparency and LP-Favorable Terms
While practices and terms regarding transaction fees varied widely until changes were brought about post-GFC, generally, a GP's aggregate transaction fees in a year were first used to cover out-of-pocket expenses they incurred (like legal, investment banking, or consultant fees) on uncompleted deals (known as abort costs). If any surplus from transaction fees remained after covering abort costs, 20 percent was typically kept by the GP, and 80 percent was credited to the LPs as reduced investment fees. This treated net transaction fees in a manner similar to investment profits under customary carried interest formulas.
While such divisions persisted for partnerships formed prior to the GFC, since around 2010, LPs have rigorously and mostly successfully pushed to eliminate the GP's share of net transaction fees (those fees after deducting abort costs) and ensured that these fees are fully credited against investment fees to reduce LPs' expenses. This shift in favor of LPs seems to be a permanent aspect of the terms of nearly all new private equity partnerships. In a decade or so, as all previous partnerships that had a distribution of these profits between the GP and LPs conclude, the GP's share of transaction fees should become a relic of the past.
