How Will You Be Paid for Managing the Fund?

Let’s discuss how investment fund managers get rich. Or, at least, how they might get rich.

THE TWO KEY “MANAGEMENT” ENTITIES — THE GP AND THE MANCO

Investment fund managers often have two “management” entities:

General Partner (“GP”). This is the legal control entity of the fund. The GP receives the carried interest earned from the fund (I explain carried interest below). The GP is often a mere holding entity (i.e., not an operating business) formed specifically for each fund. Each time you form a new fund or syndication, you form a new GP.

Management Company (“ManCo”). This is the overarching management business. It’s an operating business that might have employees, offices, and other trappings of an actual company. The GP often delegates management of the fund to the ManCo in exchange for the ManCo receiving the management fee (discussed below). The ManCo lasts forever, and a single ManCo can serve as the management company for all your funds and syndications.

Now, let’s discuss the income streams of the GP and ManCo entities.

MANAGEMENT FEES

Most funds pay the ManCo a recurring asset management fee for managing the fund. For simplicity, this is often called the “management fee” (this is not the same as a “property management” fee in a real estate fund, which is discussed below). The purpose of the management fee is to pay ManCo/GP expenses, which you will learn more about in Chapter 3.

HOW MUCH SHOULD THE MANAGEMENT FEE BE?

Management fees vary based on asset class and whether you have a multi-asset fund or a single-asset syndication (Chapter 4). Let’s look at some examples:

• Venture Capital Fund: Management fee is (i) 2 percent of committed capital during the fund’s investment period and (ii) 1.5 percent of committed capital thereafter.
• Private Equity Fund: Management fee is (i) 2 percent of committed capital during the fund’s investment period and (ii) 2 percent of invested capital thereafter.
• Hedge Fund: Management fee is 1.5 percent of the net asset value of the fund.
• Real Estate Syndication: Management fee is 2 percent of the gross revenues earned in respect of the property.

The “investment period” of a multi-asset fund is typically the first half of the fund’s life (e.g., the first five years in a standard ten-year fund). We’ll discuss the investment period in detail in Chapter 5.

ARE MANAGEMENT FEES A PROFIT CENTER?

In smaller funds, the fund principals (the humans running the show) are not getting rich off management fees. For example, a $15 million venture capital fund would generate management fees of $300,000 per year during the investment period and $225,000 annually thereafter (assuming their management-fee structure is the same as our example above). If there are two fund principals, that’s only $150,000 per year per person (before paying outside team members, renting office space, or buying equipment), even less after the investment period ends. Not quite the poverty line but often a pay cut for people leaving cushy private equity jobs to start their own funds.

In very large funds, fees can spiral upward. For example, according to its website at the time of this writing, venture capital giant Andreessen Horowitz has $43 billion in assets under management. That’s $860 million a year in asset management fees alone. Dizzying.

MANAGEMENT FEE REDUCTIONS

Some funds have “management fee offsets” — special provisions that reduce the management fee otherwise earned by the ManCo. Examples of common management fee offsets include:

Placement Fees. The ManCo team might pay third-party “placement agents” to help them raise capital. The fund will often pay for these “placement fees” initially, but the management fee will be reduced by the amount of the placement fees.

Excess Organizational Expenses. Funds typically pay to set themselves up… to a point. Many funds have an “organizational expense cap.” For example, if the organizational expense cap is $150,000, and it costs $180,000 to set up the fund, the fund will pay the full $180,000, but the $30,000 excess will be deducted from the management fee otherwise earned by the ManCo.

Transaction Fees. Some funds reduce the management fee by the amount paid in “transaction fees” to the ManCo or its affiliates by third parties. These fees include monitoring fees in private equity funds and board fees in venture capital funds. For example, a GP principal earns $5,000 a year for being on the board of a portfolio company, and the management fee is reduced by $5,000.

Not all funds have these management fee offsets, but they’re common in mid-size and larger funds.

⚠ FUND TRAP #2: FORGOING A MANAGEMENT FEE IN A FIT OF ALTRUISM

Fund managers often think they’ve discovered the El Dorado of incentive alignment. Why not forego the management fee altogether? We only get paid if LPs get paid! Buffett did it.

The problem is if you have no recurring management fee, you have no way to pay ManCo employees. While this might work in the short term (or if the fund principals are independently wealthy), it doesn’t work if the fund managers have a mortgage to pay.

I once had a client who wanted an entirely fee-free model. No management fees. No acquisition fees. No fees at all! In exchange for the lack of fees, the carried interest waterfall was especially rich (50 percent to the GP and 50 percent to the LPs after an 8 percent preferred return). The client had trouble fundraising. Eventually, a large prospective LP convinced the client to change to a more standard 2/20 model (2 percent management fee and 20 percent carried interest). After much hand-wringing, the client switched to 2/20 and successfully completed their fundraise.

OTHER FEES

In addition to the asset management fee, the ManCo might earn one or more of the following fees:

• Acquisition Fees. Fees paid when the fund buys something. For example, 1 percent of the purchase price of a business or real estate property.
• Property Management Fees. Fees paid to manage or monitor a property. For example, 4 percent of the gross revenue generated by an apartment building.
• Guarantee Fees. Fees paid to a fund principal (or an affiliate) for personally guaranteeing indebtedness. For example, 0.5 percent of the principal amount of guaranteed indebtedness.
• Disposition Fees. Fees paid when the fund sells something. For example, 1 percent of the gross sale price of a property.
• Development Fee. Fees paid for development or construction. For example, 5 percent of the hard costs of development.

There are many other potential fees, but these are the most common. Most funds won’t have all the fees listed above, but, alas, some do. My personal preference is to not go overboard with fees, but I’m not the boss! Fund managers should clearly disclose all fees payable to the ManCo, GP, principals, or any affiliates in their marketing materials and fund documents.

CARRIED INTEREST

Carried interest is the ultimate prize. Also called “promote” or “incentive income,” carried interest is the GP’s share of the fund’s profits.

In most funds, the GP gets somewhere around 20 to 30 percent of the fund’s profits (after LPs have received a return of their initial investment capital and, potentially, a preferred return).

The “distribution waterfall” is the provision that dictates the GP’s carried interest rights.

For example, let’s say an LP invests $100, and the fund doubles that investment to $200. How should this $200 be distributed?

In a very simple distribution waterfall:

• First, the LP would get $100 (a return of their capital)
• Second, the remaining $100 of profits would be distributed 80 percent to the LP ($80) and 20 percent to the GP ($20)

The $20 distributed to the GP is the carried interest. Unlike management fees (which are taxed as ordinary income), carried interest is often taxed at capital gains rates. At least for now. We’ll walk through distribution waterfalls and carried interest in detail in Chapter 7.

RETURN ON THE GP’S CAPITAL INVESTMENT (GP COMMITMENT)

In most funds, the GP invests alongside the LPs as an investor. This might be called the “GP commitment” or the “GP co-invest.” Typically, the GP’s co-investment amount is exempt from paying management fees and carried interest.

The GP co-invest is usually somewhere between 1 and 10 percent of committed capital. In smaller funds and syndications, GPs often invest at the top of that range. Some GPs commit more. Some commit nothing.

How does the GP co-invest work? Let’s say a GP invests 5 percent of the capital in a $20 million fund. That would make the GP’s commitment $1 million. If the fund returns $40 million (a 2x multiple), the GP would get 5 percent of the proceeds ($2 million), pocketing $1 million in profit.

The distribution waterfall does not typically apply to the GP because the waterfall is where the GP takes their carried interest from the LPs. As the GP doesn’t pay carried interest, they receive their distributions outside the waterfall. Some funds handle this a different way, where everyone’s capital (including the GP’s) goes through the waterfall, but this is less common in institutional funds.

HOW DO GPS FUND THEIR GP COMMITMENT?

There are three main ways GPs fund their commitment to invest:

Cash. The GP commits cash just like an LP. When the fund calls capital, the GP sends the same percentage of their commitment as the LPs.

Property. In some cases, the GP contributes property to the fund to satisfy their commitment. In a venture capital fund, this could be shares in a startup. In a real estate fund, it could be an apartment building. The property must be within the fund’s target asset class. Best practice is to obtain a third-party appraisal to avoid LP disputes.

Fee Waivers. GPs may forego fees (like management fees or acquisition fees) in exchange for a “profits interest.” For example, instead of taking a $100 management fee, the GP could take $90 in cash and $10 in equity. This can become complex — always involve a tax lawyer. We’ll cover fee waivers in Chapter 16.

Now that you have a good idea of how you’ll get paid, let’s move on to learning about who will be paid by you — your team members. A stellar team is worth the cost of building it out.