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Relief at any cost?: Fees in Tax-Advantaged Investing. Part I – defining the landscape – January 2020

Welcome to the first article in a series where we will look into the fees charged across the tax-advantaged market. The variety of structures and levels of fees charged across the market can make understanding them a particularly “taxing” process. In this article, we will outline the fees commonly associated with tax-advantaged products, including what each fee covers, (in terms of the services provided by the investment manager), who these fees may be charged to, and the different ways in which they could be charged. Throughout this series, we hope to make fee structures more understandable to the reader, and hope to bring some clarity to the costs associated with investment in the tax-advantaged space.

It should be noted that, while we have made every effort to cover the topic of fees comprehensively, it is inevitable, in such a varied market, that there are some fees charged, which are not listed, below.

Initial Fee

AKA: Entry Charge.

A one-off fee that is usually an upfront cost paid at the time of investment, calculated as a percentage of an individual’s investment. Some funds will allow this charge to be deferred. This fee is generally provided to cover the costs of a fundraise (marketing, legal costs etc). However, it can be a significant source of revenue generation for fund managers. This fee may be charged to the investor, the investee company (where it is more commonly called an Arrangement Fee – see below), or both.

Arrangement Fee

AKA: Completion Fee, Booking Fee, Finder’s Fee, Introducing Fee.

An Arrangement fee is usually charged to investee companies, and covers the administrative costs of setting up the financial arrangement. It will be a one-off payment at the beginning of a deal, charged as a percentage of the amount invested into the investee company. This percentage will vary, depending on the terms agreed between the manager and the investee company. As described above, this fee might be charged in lieu of, or in addition to, the Initial Fee to investors.

Annual Management Fee

AKA: Annual Management Charge (AMC).

An Annual Management Fee (or Annual Management Charge (“AMC”), as it is more commonly known), is an annual cost charged to either party (investor or investee company). Although the fee is calculated on an annual basis, it is usually payable quarterly, or even monthly, prorated. It is another commonly charged fee across the tax-advantaged market. The proceeds are used to cover the overheads of the manager, including staff costs, office expenses, consultants and any travel expenses incurred. For many managers, the fee serves as a significant source of revenue. The fee may be charged as a percentage of initial investment, as a fixed amount each year, or as a percentage of the latest portfolio valuation. Once more, this fee can be charged to either the investor or investee company, but usually not both.

Performance Hurdles and Performance Fees

A Performance Fee works as an incentives fee for the fund manager, and a significant portion of these proceeds are usually allocated to the investment team. This fee will be charged to investors if their investment in the fund exceeds a certain level of return, and will only apply to the amount above that level. In the tax-advantaged market, this level, called a performance hurdle, is usually based on percentage return. For example, if the investor receives 130% back on their initial investment, and the hurdle was set at 120%, then only return achieved above the 120% mark will attract the performance fee. In some cases, for VCT investments, this hurdle could also be based on a high watermark, which is the previous highest value that an investment fund has reached. This is intended to prevent a performance fee being paid where there is underperformance, or sideways movement in valuation. On the other hand, some funds charge a performance fee with no hurdle at all, whereby they will charge a fee on anything above 100% return. Further, whilst the performance fee is typically levied across the portfolio, as a whole, the performance fee could be calculated on individual assets separately (this is more typical with EIS investments). This could see an investor paying a performance fee on a single well-performing asset, even if the balance of the portfolio had been entirely wiped out.

Not only should investors consider the performance hurdle, but they should also take note of the level of performance fee charged. Quite often, managers in this space will follow the “two and twenty” rule. This means that a manager will charge investors a 2% Annual Management Fee, with a 20% performance fee, either with or without a hurdle.

Performance fees exist to motivate investment managers to deliver outperformance, but they can create a conflict, where investment managers might take on unreasonable and unexpected risk in order to attempt to hit an unrealistic target. This is especially true for Business Relief (“BR”) products, where the strategy is generally structured to preserve capital, and therefore mitigate risk. As such, it is more common to see a performance fee in EIS and VCT products than it is in BR.

Annual Administration Fee

AKA: Service Fee.

An Administration or Service Fee is a recurring charge for the direct administration of the fund, for all parties. Administration could include the processing and recording of an individual’s investment, calculating the net asset value of the fund and other performance measures. These fees can also be used to cover managing transactions, maintaining the fund’s financial books, and producing public documents such as prospectus’ and annual/semi-annual reports. The Annual Administration Fee can be charged to either investors or investee companies, but typically not both.

Directors or other Company Fees

A Director’s Fee is another fee that is usually charged to the investee companies, and applies to investment funds that will appoint a non-executive Director to each investee company’s Board of Directors. This may be a member of the investment team, or an individual from the team’s network. These individuals could have specific sector expertise relating to the company, or extensive experience in SMEs and this space, in general. This fee is effectively a director’s remuneration for their services, and again may vary greatly for a manager based on the specific circumstances of an investee company.

While some managers will explicitly state the level of fees charged to investee companies, as a fixed percentage of funds raised, or apply an explicit cap on the quantum of fees charged, others provide more informal guidance. Often, information memoranda may contain clauses such as “The manager reserves the right to levy additional fees to the investee company to meet any costs relating to investor marketing, valuation reporting, additional fundraising and administration…etc”. While it is recognised that investment managers can provide a significant level of added value to investee companies, in our opinion, it would be preferable for these fees to be laid out, explicitly.

Custodian Fee

AKA: Safekeeping Fee.

This is a common fee among smaller investment managers, which might not be large enough to receive FCA approval, and will, therefore, make use of a custodian. A custodian is a financial institution that will hold securities or other assets on behalf of another party. This ensures the safekeeping of these securities for the investor and some custodians may even offer other services such as account administration, dividend payments and other transaction settlements. A Custodian Fee, where one exists, will be charged to the investor, to cover the fees charged by the custodian. This may be charged as a one off expense or as a recurring annual/semi-annual fee.

Advisor fee

When investing via a financial advisor, the investor will have to pay a sum to the advisor for their services, which includes the advice as well as executing the transaction. This fee will be decided between the investor and the advisor and will likely be a percentage of the individual’s investment.

Execution-only/direct application fee

If an investor does not wish to use a financial advisor, they may instead carry out an execution-only or direct application. An execution-only application will be made through a company that will execute the application, but will offer no further advice. A direct application will entail an investor directly engaging with the manager of the fund. These types of applications are less favourable to managers because it means that the manager has to carry out the services usually undertaken by the financial advisor. This factor, as well as to ensure that investors are fully informed and that they meet suitability requirements before making investment decisions, causes some managers to only except application through a financial advisor. If a manager does accept these direct applications, it may increase the initial or annual management fee to cover the extra work required.

Available discounts

Some fund managers will make certain discounts available to investors, the two most common types of discount available are the early bird discount and the loyalty discount:

Early Bird discount: To help kick-start a service’s fundraising, some managers may offer a smaller initial fee or management fee for investors who apply before a certain date.

Loyalty discount: A manager may incentivise existing or previous investors in its other funds to make an investment into a service by offering smaller initial fees or management fees. This might be because the fund is a new launch, or if additional capital is required for some other reason (fundraising otherwise taking too long, for example).

Many managers will only charge a number of the fees listed above, and although this list is not exhaustive, it does cover the fees we most commonly see in the tax-advantaged market. It is important to note that these fees could be referred to under a number of different names: investors should keep this in mind when doing their own research into the cost of a service. With the most common types of fees defined, forthcoming editions of View from The Bridge will take a more in-depth look into some of the different structures which can be used and the benefits and drawbacks of the variations, form an investor’s perspective.