Alternative Insight – July 2018

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Private Fund Economics – What’s Changed in 2018?

Every year, MJ Hudson surveys the core economic terms of a large, diverse sample of recently-closed funds in the private equity, venture capital, growth capital, infrastructure, real estate and private debt sectors, where we have advised either the fund manager or a prospective investor.

In this article, we consider what’s changed in fund economics since last year. If you would like to know more, please check out our new survey on fund economics in 2018.

Management Fees

The traditional annual fee of 2% of committed capital remains the most ‘popular’ fee level – around two-fifths of the funds in our survey charged 2%. But there are signs that 2% is waning as the market standard:

• Funds charging a 1.5% management fee scooped 59% of committed capital, even though they accounted for just under a fifth of funds in the survey (by number).
• Just 8% of the capital committed to the funds in our survey was subject to a 2% fee, a sharp decline from the stonking 62% we found in our 2017 survey.

Weighted by capital, we found the average management fee declining to 1.49%. But this average camouflages a bifurcation of the market according to fund size:

• Small and mid-size funds generally set management fees at or near 2%.
• Large-cap funds are taking advantage of scale to reduce their fees, typically to around 1.5%. For mega-funds, in particular, the sheer size of the capital commitments flowing in allows their sponsors to maintain (or even increase) total fee income even while dropping the headline percentage rate.

Nearly 12% of the sampled funds charged fees in excess of 2%, but they raised only about 3% of committed capital. The majority of these 2%-plus funds were in the venture capital sector, but investment strategy may not be the determining feature here, because they were invariably small-cap or mid-cap funds.

At the other end of the spectrum, 20% of funds (by number) got by with a management fee of 1.25% or less; they accounted for nearly 16% of the committed capital in the whole survey. The funds in this ‘lower cost’ bracket included buyout, infrastructure, energy, venture, credit and secondaries funds; no particular investment strategy predominated.

Fee Discounts

Headline fee rates don’t necessarily tell the full story. Almost a quarter of the funds in our survey built a fee discount of some sort into their LPA, arguably the most ‘above board’ way to offer discounts to investors. This represents a dramatic increase in the popularity of discounting – in our 2017 survey, less than 5% of funds (by number) did the same.

The most popular discount trigger was the size of an investor’s commitment – 54% of the funds we surveyed linked the discount to commitment size either on its own or in combination with the investor being an “early bird” (i.e. admitted in the fund’s first closing).

Managers are often willing to lower fees for particular investors on an individual basis. These special deals normally end up in investor side letters. Depending on how comprehensive the fund’s MFN obligation is, these individual discounts may remain undisclosed or, if disclosed, may not be offered to the investor base as a whole. The persistence of these practices means that a fund’s true fee level is likely to vary from investor to investor.

Stepped-Down Fees

In 87% of funds surveyed, the management fee steps down to some lower level once the investment period expires. This may involve reducing the fee percentage (the method used in 13% of the funds in our sample) or applying the same fee percentage to a smaller baseline amount (used by 54% of sampled funds) or some combination of the two (33% of sampled funds).

Hurdle Rate

Despite a decade of persistently low interest rates, the traditional 8% hurdle remains intact as the market standard – 75% of capital raised by funds in this year’s survey was committed to funds with an 8% hurdle. This is down on last year’s survey, when a remarkable 93% of capital was committed to funds with an 8% hurdle, but up on the 66% recorded for the same category in the 2016 survey.

It’s still rare to encounter funds without a hurdle. Only 4% of capital was committed to funds with no hurdle (compared to 7% in last year’s survey). Rather than dispense with the hurdle altogether, a small but growing number of funds are pitching sub-8% hurdles – they attracted around a fifth of committed capital in this year’s survey.

Carried Interest

85% of the funds in the survey set carried interest at the traditional 20% level, but there is also a general continuation in the trend towards more innovative carry structures:

• 17% of the funds in our survey used ratchets, varying the carry percentage according to the overall level of investor returns.
• Some larger funds gave investors the option to mix different rates for management fees and carried interests, with higher carry percentages compensated by lower fee percentages, e.g., choosing between 1.5% management fee and 20% carry versus 0.75% management fee and 30% carry.

Historically, UK/European-based funds tend to use (LP-friendly) whole-fund carry, while U.S.-based funds favour (GP-friendly) deal-by-deal carry. The competitive balance between the two forms of carry has yo-yoed in recent years, although the data in this year’s sample show funds in the two main markets nominally conforming to type – 80% of UK/European-domiciled funds opted for whole-fund carry, compared to only 36% of Delaware-registered funds.

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