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Management Fees for Emerging Market VC Funds Should be Predictable

Posted By Dave Richards, Capria Ventures, Wednesday, March 21, 2018

The traditional PE-birthed model for management fees does not align interests for LPs and GPs for emerging market VC and early-growth PE funds that are under $100M


As a global emerging market fund investor, we evaluate more than 200 VC/PE fund proposals per year across Africa, Latin America, and South & Southeast Asia. We also talk every week with multiple fund investors (most call themselves “LPs” or limited partners) to get their feedback on funds that they are seeing and evaluating.


The Fees Tug of War

 
One of the most focused on and hotly discussed topics is fees. Fund managers (most call themselves “GPs” or general partners) are “defending” their need for the proposed management fees in order to have sufficient resources to professionally manage their investing strategy, with the largest item being the principals’ and staff’s compensation expenses and profit-sharing fees that give them upside if they can deliver profits (aka “carry”). The LPs are trying to understand why the GPs need to pay themselves such large salaries and question if there is sufficient “skin in the game” from the GP principals to align interests long-term. The LP’s concern is that GPs can be paid handsomely, or maybe even excessively, via management fees even if the GPs invest their money poorly and don’t deliver expected returns. The default ask by GPs in under $100m funds is “2 & 20” – 2 percent per year as management
fees and 20 percent of carry. These two items are generally the core “fee package”. I have previously shared about a better way to align LP/GP interests on carry, so here I’m going to focus on the management fee component.

I Approach the Management Fee Conversation from a Different Angle As a fund investor, I often ask the GP the following questions:

 What is the smallest annual operating budget you need to do a quality job of managing this fund? And what is your preferred budget? Explain both scenarios with trade-offs.
 You are proposing to increase your firm’s annual operating budget by 200% (or whatever it is) with additional fees generated by this new fund. Where will you be spending the incremental fees?

Why do I ask these type of questions? Because I really don’t care about what percent management fee they are asking for, what I care about is what size of operating budget they need and the logic behind that. E.g. how much is going to hire new staff, compensate current staff more, move into a fancy new office, upgrading to business class travel, paying for overpriced attorneys, and … drum roll please … going to pay principals.

What is the most common answer? Poor quality “hand waving” type answers. A remarkable number of managers, even experienced ones, have not really thought through how to address such a straightforward question. And they generally won’t admit it. They haven’t done the work to research and prepare a bottoms-up budget forecast. They just assume it is ok to ask for 2% or even 2.5% “because doing business is expensive in this place.” I think to myself, would they invest in a startup business where the CEO hadn’t done their homework on revenue forecasts and operating budgets? See my other post on why fund managers need to be entrepreneurs as well.


So, I send them back to prep a bottoms up operating budget forecast for the “minimal” and “preferred” scenarios and ask them to send to me before our next call. Most LPs Focus on Incentivizing Capital Deployment Beyond Investment Period. In the 2% management fee scenario, most old-school LPs are “ok” with the basis of the 2% fee to be “committed capital” during the investment period (usually 3-5 years for VC funds). Then LPs want the basis of the management fee to shift to something like “net invested assets” – that is, the amount that has been deployed to investee companies.

1 . The thinking is that this will motivate the GP to quickly deploy reserves which is somehow correlated to speeding up when they will be able to exit the investments. They also prefer to not pay management fees on management fees and fund expenses.

2 . The problem with this approach is that this results in a dramatic cliff on fees right after the investment period ends. For instance, VC funds often initially invest smaller amounts in many companies and then hold substantive reserves to double and triple down on the best companies that emerge. So, it is not uncommon at the end of the investment period for the fund to have deployed only 40-50% of the committed capital. This would mean a 50% drop in management fees right after the investment period.

Then It Gets Even More Complicated.

So, then often the discussion turns to the basis post investment period to being “net invested assets + something else”. Often the something else is some quantity of reserves, but then this gets really complicated to define. Here are the problems with this approach to post investment period management fees

thinking:

1 This is generally the cost basis of investments made by the fund, less the proportion of shares sold. So, if the fund invested $1m in a company, the value would initially be $1m. If the fund sold 50% of its shares in that company, then the value would be reduced to $500k.
2 If you have a $50m fund and the forecast is for $10m in fees & expenses over the 10 year duration of the fund, then the fund’s investable capital is $40m. When you pay management fees based on committed capital, you are paying it on the full $50m.

 The GP is incentivized to increase net invested assets ASAP at or after the investment period whether this makes sense or not in order to earn higher management fees;
 The GP is incentivized to hold on to investments longer and write them down/off more slowly because that would reduce management fees post investment period;
 The GP will need to start fundraising for a successor fund earlier to reduce the period of lower management fees after the investment period – paying less attention to their current fund and its performance; and
 GPs are (understandably) going to ask for a higher management fee during the investment period due to the unpredictability of fees post investment period.

But the biggest problem with this typical approach is that it creates unpredictable management fees for both the GP and the LP. The net is that this is an over-engineered fee structure with a lot of perverse incentives that misaligns the LP and GP interests.


Predictable “Budgeted” Management Fees are a Better Solution

I believe there is a simpler and much more aligned approach to setting management fees – a pre-defined management fee budget for the entire fund duration. This approach defines a year-by- year budget which recognizes that there is some additional heavier lifting in the early years as the portfolio is being selected and then a predictable, graduated budget in the outer years. This enables the GP is focus on maximizing the fund’s results without having to think about how their buy/sell decisions are impacting their operating revenue, nor does it incentivize the GP to pre-maturely raise another fund.

Example: For a $50m fund, the agreed budget might be $1.25m for the first 2 years and $1m for the next 2 years of the investment period. Then reducing to $850k in years 5 & 6, $700k in years 7 & 8, etc. (Of course, you could convert this back into a percent of committed capital for each year.)

The discussion then can focus on what the right budget is based on the investment strategy. And you could even decide to have checkpoints along the way managed by the fund’s advisory council (often called LPAC, with members from the fund’s largest investors) to review the budget needs and have some authority to increase or decrease modestly. But be careful about making it too easy to change the budget as this could create unintended misalignments.


Summary: Pre-determined budgets for management fees for the duration of the fund are a
benefit to both fund managers and fund investors creating better long-term alignment.

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