Happy Friday, Funds Family!

Today we’re talking about the fun stuff…money! 🤑 

Ultimately, there are many reasons to want to raise an investment fund.

• You get to work on interesting deals (often bigger deals than you’d be able to take down by yourself)

• You get to meet interesting people

• You can be your own boss and work flexible (if many) hours

But, alas, the allure of riches 💰️ is certainly why many seek to raise an investment fund or syndication.

Here, we’ll discuss how investment managers (GPs) get paid.

📒 Quick note on terminology

As we’ll discuss in a future article, investment fund managers often use two “management” entities: (i) a general partner entity to receive the carried interest and (ii) a management company entity to receive fee income.

For this article, we’re just going to refer to the “general partner” receiving these fees, but in practice, the flow of funds often looks something like the image below. 👇️ 

1. Management fees

Most funds pay the GP a recurring asset management fee for managing the fund. We’ll call this the “management fee” in this article.

The purpose of the management fee is mainly to pay GP overhead, including:

• Salaries

• Offices

• Equipment (like laptops and software)

A typical management fee in a real estate or private equity fund might be 2% of committed capital during the investment period and 2% of invested capital thereafter. (By the way, we discuss management fees and investment periods in this article on the timeline of a fund’s life.)

A management fee in a venture capital fund might be 2% of commitments during the investment period and 1.5% of commitments thereafter.

A hedge fund might have a fee of 1.5% of the fund’s net asset value (assets minus liabilities).

💸 Are management fees a profit center?

In smaller funds, the GPs are not making out like bandits 🦹‍♂️ on management fees.

For example, a typical $15 million VC fund would generate management fees of $300k per year during the investment period and $225k annually thereafter.

If there are two GPs, that’s only $150k per year (before paying outside team members, renting office space, or buying equipment). 💵 

Of course, in megafunds, fees can spiral upward.

For example, Andreessen Horowitz raised $7.2 billion this year. At 2% of committed capital, that would be $144 million a year in fees. Big time fees! 💵 💵 💵 💵 💵 💵 💵 💵 💵 💵 

Management Fee Reductions ⤵️ 

In some funds, management fee offsets reduce the management fee otherwise earned by the GP.

Examples of common management fee offsets include:

• Placement fees. GPs sometimes pay third parties to help them raise capital. The fund will often pay for these “placement fees” initially, but the management fee will be reduced. ⚠️ Please note you shouldn’t pay people to find you investors unless they are licensed broker-dealers.

• Excess organizational expenses. Funds typically pay to set themselves up…to a point. Many funds have an “organizational expense cap” (for example, $150k). If it costs $180k to set up the fund, the fund will pay for it initially, but the $30k excess will reduce the management fee.

• Transaction Fees. Many funds will reduce the management fee by “transaction fees” paid to the GP by third parties. We discuss these fees in “Other fees not paid by the fund” below. 👇️ 

Not all funds have these management fee offsets, but they’re common in mid-size and larger funds.

2. Other fees paid by the fund

Fees fees fees.

Depending on the type of fund, the GP might charge one or more of the following:

• Acquisition fees. Fees paid when the fund buys something. An example is 1% of the purchase price of a business or real estate property.

• Property management fees. Fees paid to manage or monitor a property. An example is 4% of gross revenues from a property.

• Guarantee fees. Fees paid to a GP (or an affiliate) for personally guaranteeing indebtedness. An example is 0.5% of the principal amount of guaranteed indebtedness.

• Disposition fees. Fees paid when the fund sells something. An example is 1% of the gross sale price of a property.

• Development fee. Fees paid for development or construction. An example is 5% of the hard costs of development.

There are many other potential fees, but these are the most common. Usually, a fund wouldn’t have all of these fees. But some do…

⚠️ I would suggest clearly disclosing these affiliated fees in your fund’s marketing documents. We often explicitly mention them in the LPA as well.

3. Other fees not paid by the fund

Sometimes a third party might pay a fee to the GP. Depending on the fund, the amount of these fees might reduce the management fee (as mentioned above).

These fees include board fees, monitoring fees, closing fees, etc. 💸 

The list of potential side fees is long and varied. 📜 

Example: Let’s say a GP gets paid $1,000 per year for sitting on the board of a portfolio company. In many funds, the GP would get to keep the $1,000. However, the management fee would be reduced by $1,000 to “pay back” the fund.

The rationale is that the only reason the GP is getting the $1,000 in the first place is because the fund is investing LP money. So the $1,000 should really belong to the fund.

⚠️ If you’re a GP planning to earn fees not paid by the fund, I would suggest disclosing these fees in the offering documents you provide to potential fund investors.

4. Carried interest

This is the big one! 🏆️ 

A GP’s carried interest is its share of the profits.

In many funds, the GP gets somewhere around 20-30% of the fund’s profits.

So, if LPs invest $100 and the fund returns $200, the GP would get to keep $20:

1. First, the LPs get their $100 back

2. Second, the remaining $100 (the profit) is split 80% to the LPs ($80) and 20% to the GP ($20)

The method for distributing a fund’s profits is called the distribution waterfall 🌊 and it can get much more complicated than the simple example above.

In a future article, we’ll examine many, many, many ways investment funds split profits between GPs and LPs. 🤓 

5. Capital interest (co-invest)

In most funds, the GP co-invests alongside the LPs as an investor.

Everyone has a different opinion on this, but the GP co-invest is usually somewhere between 1-10% of committed capital. On smaller funds and syndications it’s often on the higher end of that range. Some GPs commit more.

A GP’s co-investment amount is often exempt from paying fees and carry. 😎 

Example: Let’s say a GP invests 5% of the capital in a $20 million fund. As a result, their total commitment would be $1 million.

📈 If the fund returns $2 million (a 2x multiple), the GP gets the whole $2 million, pocketing a $1 million profit. The distribution waterfall does not typically apply to the GP.

🤔 How do GPs fund their GP commitment?

There are three main ways GPs can fund their co-investment.

1. Cash. This is the simplest. The GP commits cash just like an LP. When the fund calls capital, the GP sends the same percentage of its commitment as the LPs via wire transfer.

2. Property. In some cases, GPs may satisfy their commitment by contributing property to the fund. 📊 In a venture capital fund, these could be Series A shares of a hot startup. 🏘️ In a real estate development fund, it could be raw land to be used for development. Obviously, the property contributed must be something that’s within the fund’s target asset class. You wouldn’t contribute an apartment building to a private equity fund. ⛔️ Additionally, GPs should be very transparent about the price at which they’re contributing the property. Having a third party appraise the property is best practice. You don’t want to open yourself up to LP complaints of impropriety. 🧑‍⚖️ 

3. Fee waivers. GPs also have the option to forego fees (like management fees and acquisition fees) in exchange for a “profits interest” in the fund. So, instead of taking a cash management fee of $100 a quarter, the GP could take $90 in cash and get $10 of fund equity instead. This could take up an entire article and gets complicated rather quickly. You should absolutely work with a good tax lawyer. I know some 😉 

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.