Introduction
One of the key aspects of a fund formed as a limited partnership is its financial terms. The financial terms affect the level of return to investors on their capital invested into the fund, and the level of carried interest that a general partner (a fund manager) may expect to get from the performance of the fund. This note briefly outlines the elements of the financial terms of the operation of a fund structured as a limited partnership – namely the fund's expenses, management fees payable to the fund manager and the order of priority of distribution as between the investors. A key point to note is that investors should pay attention to and negotiate the financial terms of a fund, as they significantly affect the investment return.
Management fee
A limited partnership agreement for a private equity fund and venture capital fund would normally provide for the payment of a management fee calculated in respect of each year. Such a management fee, as the name suggests, is paid to the general partner (or a fund manager) for the management of the fund. Management fees are paid regularly irrespective of the financial performance of the fund.
Management fees are calculated in respect of each financial year, but they can be paid once in a year or on a semi-annual basis or they can be paid each quarter, in each case whether upfront or in arrears. If the commencement of the fund is not subject to any conditions precedent, a management fee will start accrue to the general partner (or the fund manager) with effect from the first closing date, i.e., the date on which the first round of limited partners are admitted to the partnership (excluding an associate of the general partner / fund manager).
The rate of a management fee may vary between 1 to 2.5% of the capital committed to the partnership. The management fee would normally remain flat at the same level during the investment period, i.e., the period during which the fund will make or acquire investments. The rate would normally be scaled down after the end of the investment period either by reference to fee percentage or base for calculating the percentage or their combination.
An alternative to a management fee is a priority profit share. A priority profit share is a guaranteed share of profit payable to the general partner in respect of an accounting period. A distinguishing characteristic of a priority profit share is that it is not normally treated as the fund's expenses. A priority profit share is used in the United Kingdom with a view to reducing the risk that UK value-added tax is levied, as the priority profit share is not treated as a fee charged for management services.
The ILPA Principles 3.0 of the Institutional Limited Partners Association recommends that the management fee should be based on reasonable expenses related to the normal operating costs of the fund.[1] This implies that the management fee should not be the main source of income for the general partner / fund manager. It must be sufficient to cover overhead costs of the general partner / fund manager (such as salaries of employees, office rents and etc.). The main source of profits for the general partner / fund manager should comprise carried interest.
Other fees
The general partner / fund manager or its associates may, in the ordinary course of its business, provide various services to portfolio companies in which the fund holds investments. Such service may include transactional, monitoring, management, consulting and other services, for which the general partner / fund manager or its associate may charge the portfolio companies fees ("ancillary services"). Further, the general partner / fund manager or its associate may also receive break fees which may be paid by a counterparty of the fund in respect of a transaction which does not proceed to completion.
Generally, limited partners (i.e., investors who makes investments into the fund) do not normally approve of the ancillary fees that are paid to the general partner / fund manager. There are several reasons for such an attitude. First, such ancillary fees may give rise to a misalignment of interest between the general partner and limited partners. Second, such ancillary fees ought to be paid to the funds rather than to the general partner or its associates as they are earned in the course of the investment activities of the fund. Third, an opportunity to earn such ancillary fees would distract the resources of the general partner from its primary task relating to the management of the fund. Limited partners (investors) generally prefer the general partner to earn its profits out of carried interest distributions.
There are different approaches that the parties may take in relation to the ancillary fees. One approach that the parties may utilise is to prohibit the general partner or its associates from receiving any such ancillary fees at all save for a limited number of specified exceptions. Alternatively, the general partner may be permitted to receive and retain for its own account any ancillary fees, providing that abort costs incurred by the fund in connection with any investment which does not proceed to completion are first paid out of such ancillary fees. Further, it is routinely agreed between the parties that any ancillary fees that are received and received by the general partner or its associates for their own account will be credited against and reduce the management fee (see above). Thus, partners of limited partnership may agree that the whole amount (or only 50 per cent) of the ancillary fees will be offset against and thereby reduce the management fee. ILPA recommends that any portfolio company fees that are charged should be 100% offset against the management fee and subject to standard disclosure.[2]
Expenses
The general partner will normally be responsible for its overhead costs (such as the salaries and benefits of its directors, employees and costs in providing office facilities and equipment), and such costs will be covered by the management fees earned by the general partner / fund manager. In addition, the general partner may be expressly made responsible for further expense items (for example, travel expenses or placement fees).
The operating expenses of the fund (which include fees charged by custodians, depositories, lawyers, valuers, auditors and others) are paid by the fund, i.e., such expenses are funded through drawdowns of capital commitments of the limited partners or paid out of the income proceeds or capital proceeds. A limited partnership agreement will typically specify which expenses will be covered by the fund and which expenses will be paid by the general partner / fund manager, and some expense items and their caps may be the matter of negotiation. For example, the expenses for the establishment of the fund, reimbursements paid by portfolio companies, the fees and expenses of the members of the investment committee, brokerage fees, fees due to directors, nominated by the general partner / fund manager to the portfolio companies, may be excluded from the list of the fund's expenses, and thus will be covered by the general partner / fund manager.
Distribution of profits
Cash received by the fund will be distributed among its investors. Cash proceeds received by the fund comprise two elements: (a) income proceeds (for example, dividends, interest on loan notes or bonds paid by portfolio companies) and (b) capital proceeds (for example, consideration received on realisation of shares in portfolio companies, on repurchase or redemption of shares or special dividends). Cash proceeds will be distributed among the partners in accordance with a specific order of priority.
As the statutory instruments applicable in the AIFC do not prescribe any particular order and priority of payments to be applied to any distribution of proceeds (except where the limited partnership is insolvent), such an order of priority is usually agreed between the partners in the limited partnership agreement. The partners are free to set any order of priority to fit their own expectation. Below is the basic order of distribution of proceeds.
First, cash proceeds from realised proceeds are used to pay the limited partners an amount equal to their invested capital either as loan or capital. This affects the timing when the general partner will receive its carried interest (see below). There are basically three models that can be used to determine this point:
(a) in the first model, the limited partners are only paid back such portion of their commitments as was used to fund the acquisition costs of a realised investment giving rise to the relevant distribution (an American waterfall model or a true deal by deal carry); or
(b) alternatively, the limited partners may be first paid until they receive the total of their commitments invested into the fund (a European waterfall model or a back-end-loaded carry); or
(c) the third model requires that the limited partners receive an amount equal to a portion of the commitments used to fund the realised investment and the investments that are permanently written down plus a proportion of the fund expenses and the management fees allocated to those investments (a hybrid model).
The choice of the distribution model specifies the rights of the general partner and of limited partners to receive proceeds from an ownership interest in a partnership. The true deal by deal carry is less favourable to limited partners as it does not, for example, take account of realised or unrealised losses arising from other investments (such as unreturned capital used to fund a previously realised investment or permanent written-down of an investment), while the back-end-loaded carry model is more favourable to the limited partners. ILPA recommends using the European model or at least the hybrid model.
Second, cash proceeds will then be applied to the limited partners in the payment of the preferred return on the distributions received by them pursuant to the first tier. The preferred return is a minimum level of profits that the investors would expect to receive on their capital contributed to the fund. The preferred return may be expressed in a limited partnership agreement either as an interest rate (for example, 6% or more) or an internal rate of return (IRR). The rate of return is calculated in a way as to ensure that the yield on risky investments into illiquid assets (such as untraded shares in private companies or participatory interests in LLPs) is higher than or competitive with those on alternative investment strategies.
Third, the distribution to the extent that is left over after the sum being paid pursuant the second tier will go the general partner in the payment of a catch-up or make-up on the preferred return. A catch-up or make-up would normally be expressed as the percentage proportion of the sum of the preferred return paid to the limited partners and the amount to be paid pursuant to this third tier of the distribution waterfall. Thus, if the profit share of the general partner paid as part of the carried interest equals 20 percent (see the fourth tier of the distribution waterfall below), then a catch-up (or make up) payment will be equal to 20 percent of (a) the preferred return paid to the investors pursuant to the second tier and (b) the amount to be paid pursuant to this third tier.
Fourth, the remaining balance will split between the general partner and all the limited partners in accordance with the pre-agreed proportion. For example, the parties may agree that 20 per cent of the remaining balance will be paid to the general partner's share and 80 per cent of the balance will go to the limited partners. The split is a matter of negotiation between the general partner and the limited partners.
The payments which are due to the general partner pursuant to the third and fourth tier of the distribution waterfall described above is normally referred to as carried interest of the general partner / fund manager. This is paid after the return of the capital invested by the investors and the payment of the preferred return to them.
Takeaway
When determining the key financial terms of the fund, it is advisable to expand the review beyond management fees and carried interests. Attention should also be paid to the expenses to be covered by the general partner (the fund manager) and those to be covered by the fund, other alternative fees to the general partner (the fund manager), and the order of priority of distributions.
For further information please contact:
Rashid Junusbekov
Counsel
Disclaimer
The information in this article does not constitute legal or professional advice. No part of this articles should be relied on or used as a substitute for legal advice. The information in this articles is for general information purposes only. It should also be appreciated that the law may have changed since the date of this article.
English law is not part of AIFC law and is not a default legal system. The AIFC Court may (but not obliged to) have regard to the case law of England and Wales or any other common law jurisdiction. Therefore, any reference to English law or English case law are provided only for the illustration of how AIFC law could be applied and should not be taken as an assurance that the AIFC Court will eventually apply them.
[1] IPLA Principles 3.0: Fostering Transparency, Governance and Alignment of Interest for General and Limited Partners, page 12.
[2] IPLA Principles 3.0, страница 12.
