Introduction
A key factor for a successful fund is a financial incentive to a fund manager to generate profits for the investors of the fund. The financial incentive is aimed at ensuring that the financial interests between the fund manager and the investors are aligned. For that reason, it is advisable to ensure so far as possible that financial reward for services of the fund manager is linked to the financial performance of the fund. In practice, the fund manager’s reward comprises two elements: (a) a management fee which is normally paid regardless of whether the fund generates profits, and (b) a carried interest which is distributable out of available proceeds after the capital and the investment return are paid to the investors.
Private equity funds and venture capital funds are traditionally formed as limited partnerships, as the limited partnerships offer the flexibility in structuring the governance framework and the return of capital and typically act as private investment funds. Private investment funds are the funds which are offered privately – not by way of a public offer – to a limited group of investors who are professionals. Such private investment funds are less regulated by financial regulators. In the AIFC, such funds are "exempt funds".
As a management fee for the fund management services are paid regardless of the performance of the fund, the interests of the general partner and the investors are not aligned on this point. The larger a management fee is, the greater misalignment of interests it creates.[1] That said, the general partner (the fund manager) needs to attract and retain skilled employees who are able to search for and manage investments. To that end, the investors will focus on some aspects of the management fee when negotiating the terms of a limited partnership agreement.
The Institutional Limited Partners Association ("ILPA") recommends that the management fee be based on reasonable expenses related to the normal operating costs of the fund.[2] In other words, the management fee should not be a primary source of profits for the general partner (the fund manager). It must be adequate to cover the overhead costs of the general partner (the fund manager), such as salaries and remuneration of directors, employees, rent expenses and etc. The primary source of profits for the general partner (the fund manager) should be a carried interest.
Investment period
It is not uncommon that, by the time the first investors are admitted to the fund (i.e., the first closing date), the funds do not have any portfolio investment which may give rise to a profit.[3] The investors do not typically contribute capital or advance loans to the fund at the time of their admission except in respect of an equalisation payment, but they commit themselves to provide funding in the future as and when called upon by or on behalf of the fund to finance the acquisition of a portfolio investment. During this stage, called as the investment period, the fund actively searches for and acquires investments (such as shares and participatory interests in portfolio companies) funded by drawdowns of the commitments from the investors as and when required. The investment period typically runs around 5 years.
During the early stage of the investment period, funds do not normally have a source of cash to cover management fees other than the commitments of the investors. However, the drawdowns of the commitments utilised to pay the management fee will reduce the amount of the available commitments to fund any further potential investments, thus depressing the potential investment return to the investors. The way around this may involve an arrangement that the funds applied to cover the management fee will be provided on top of the available commitments or will be further available for re-investment.
The management fee is typically calculated and paid in respect of a period that commences on the first closing date. However, a risk that the fund manager will not be able to source a first deal for a protracted length of time after the first closing date should not be discounted. There could be a variety of factors at play, for example, suitable investments may simply not be available due to a limited market. We came across instances where there were significant delays between the first closing and the first investment. Such a situation may create a risk that investors will be paying management fees in the circumstances where the fund has not even commenced their investment activity. The investors will ensure that a limited partnership agreement will cater for that eventuality.
A fund manager typically manages several funds at a time. It is not uncommon to see a limited partnership agreements prohibiting the fund manager from forming a successor fund having an investment policy substantially similar to the fund it currently manages without consent of limited partners (by a specified level of consent). Such a restrictive provision normally operates until the end of the investment period or until such time as a specified level of the commitments has been invested or committed for investments. However, in the circumstances where the fund manager is permitted to form a successor fund, the fund manager will have an additional source of funding for its ongoing costs. The investors may factor additional fees accrued on successor funds to scale down the amount the management fee by applying a reduced percentage.
The management fee may be used as an incentive. The management fee percentage may be further depressed if, for example, the general partner (the fund manager) sources and executes deals not as many as initially expected or acquires investments that do not fall within an investment policy or fails to achieve key performance indicators. The percentage of a fee may be scaled down if, for example, the general partner (the fund manager) fails to secure a commitment of a third party investor or, the other way round, the percentage may be scaled up if further round of closing is achieved beyond a specified amount of new commitments. A limited partnership agreement typically specifies whether a step down in the management fee will take effect automatically or with the consent of the investors by a specified majority.
Divestment period
After the end of the investment period, the ability of the general partner to make further investments will be limited. That is because the general partner (the fund manager) will not be able to make further calls for capital from the investors for the purpose of acquiring new investments in new portfolio companies. During this period, the investment activity of the fund will essentially be confined to monitoring and realisation of the portfolio investments, i.e., the fund will gradually liquidate its positions in the portfolio investments. The liquidation period may last around 5 years, subject to a single or two extensions by up to one year by the general partner (the fund manager). In an ideal situation, a fund would realise capital gains from the sales of its portfolio investments and distribute capital proceeds to the investors during the initial term of the fund life.
As the commitments of the limited partners will also be used to cover the expenses of the fund, the total acquisition costs of the portfolio investments will only represent a portion of the whole committed capital of the investors. During the investment period, a management fee is normally based on the total commitments.[4] Following the investment period, the base for the calculation of the management fee typically changes to a more reduced value. It is commonly negotiated that the management fee will then be based on the invested capital. This will depress the amount of the management fee. In such a case, the general partner (the fund manager) will seek to protect its position in case an investor fails to advance the amount which is subject to a drawdown notice for the purpose of making an investment. The general partner may improve its position by agreeing to apply the management fee percentage to the aggregate amount of the invested capital plus the undrawn commitments which still remain available for a drawdown (for example, to cover the fund's expenses).
Alternatively, a limited partnership agreement may calculate a management fee as a percentage on the aggregate amount of the acquisition costs of the investments held by the fund. In such a case, that part of the capital that is outlaid to cover the expenses of the fund (including the management fees paid in respect of the previous accounting periods) will not be factored to calculate the management fee. As the fund will be selling its portfolio investments until the time when its affairs are wound up, the calculation of the management fee in this way will taper off the amount payable to the general partner (the fund manager). A limited partnership agreement typically specifies events which constitute the realisation of an investment in order to reduce the base for calculating the management fee (for example, the realisation may embrace the payment of special dividends, or the redemption of an investment funded out of the proceeds from the sale of the assets of a portfolio company).
The base to which the percentage is applied to calculate the management fee do not factor an unrealised loss (that is a depreciation in value of the investments in portfolio companies below their acquisition costs). However, there could be objective external eventswhich may result in a permanent impairment to the value of the portfolio investments. A limited partnership agreement typically factors permanent write-downs in the calculation of the management fee. The general partner may insist on a step up in the management fee to take account of appreciation in the value of the portfolio investments or at least to offset the capital appreciation against the permanent write-downs.
The parties may agree that the management fee rate may be scaled down, or no management fee will be paid if, for example, the life of the partnership has been extended beyond the original term or the winding up of the partnership has formally commenced.
Takeaway
A management fee is critical for investors to protect their financial interests. Investors intending to invest into a fund should review and, where necessary, negotiate the provisions governing the calculation and the payment of the management fee in order to ensure that the management fee is structured fairly and and aligned with the financial performance of the fund.
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] ILPA Principles 3.0: Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners, page 12.
[2] ILPA Principles 3.0: Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners, page 12.
[3] However, it is not uncommon for a fund manager to acquire and hold warehoused investments before a fund is established with a view to attracting new prospective investors who have not previously dealt with that fund manager.
[4] Private equity funds and venture capital funds typically invest into shares of private companies those shares not traded or listed on a stock exchange. For that reason, such funds do not typically use net assets value as a base for calculation of a management fee. Although it is possible use the net asserts value for the purposes of calculating management fees, this may involve administrative and/or financial resources to prepare valuation reports.
