Much of what LPs will need to look out for focuses on fees and expenses, both in how they are calculated and how they are charged. Offsets to the standard charges can be a much overlooked item in a limited partnership agreement.
The most common offset today is fee income earned by the general partner or associates from the underlying investments being applied as a reduction to overall management fees. These fees and offsets are important for LPs to understand and keep track of. In recent years several large private equity firms, including some of the most well-known, have been challenged by the SEC over a lack of discipline, accuracy or disclosure in allocating amounts and communicating the scale of such transactions to LPs.
For example, two fund managers have been fined for failing to adequately disclose details of accelerated monitoring fees to investors. In each case, monitoring fees payments by fund-owned portfolio companies were accelerated prior to the companies' sale or IPO. By charging these fees prior to the event, the SEC determined the fees had reduced the value of the companies prior to their sale or IPO, which was effectively to the detriment of fund investors The investigations concluded that the managers had failed in their duty to properly disclose the information regarding the monitoring fees acceleration and were instructed to pay disgorgement amounts along with interest to affected investors and a penalty to the SEC.
It's not uncommon to see a 100% offset of fee income generated by GPs or affiliates from the portfolio, although a lower rate is sometimes used when the core management fee is itself a lower percentage. Typically offsets are made for transaction fees, monitoring, director fees, underwriting fees and other fees such as abort/broken deal/breakup fees, and advisory fees. Items such as excess organizational expenses and the placement fees also are generally covered by the manager, or offset against management fees if drawn separately.
And about those management fees. While a 2% fee is a historic norm and common on smaller or midsize funds, we're seeing a lot more variation on the commercial terms today. The standard “2 and 20” is something that is challenged, particularly in larger funds where it would make for a high absolute level of charges. Indeed this very traditional fee structure might become the almost exclusive territory of only the largest brand-name firms that continually post stellar returns.
In an effort to make the fee-carry structure reflect current sensitivities, one option that limited partners are exercising with greater frequency is to secure rebates through side letters. Such personal terms, in cultivating the long-term relationship, can be given to preferred LPs that commit capital at a fund's first close or to those that invest significant commitments. LPs and some regulators now routinely demand greater transparency and disclosure of key side-letter terms offered across the investor base — whether on fees, co-investment opportunities or other commercial points.
Another variation that bears note is the way management fees are charged. Some funds charge in a more granular way, with fees based on the mix of what has been drawn and what has not yet been drawn, charging a different percentage for capital drawn vs. not. And don't forget about the post-investment period, when fees are generally lower — and subsequently tail off.