Whether you’re an active investment manager (GP) or a passive investor (LP), you need a deep understanding of how GPs get paid. GPs need to put food on the table, and LPs don’t want to overpay.
In this article, we’ll discuss three types of fees earned by GPs in investment funds and syndications:
- Management Fees
- Other Fees (for example, acquisition fees)
- Carried Interest
Let’s dive in!
A quick note on terminology
GPs often create two “management” entities to manage their fund or syndication:
- A general partner entity to receive the carried interest
- A management company entity to receive fee income
For simplicity, we’ll refer to the “GP” 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)
- GP-level accounting and tax returns
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.
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).
Your lawyer can help you understand the “market” fees for each asset class.
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 annually 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 mega-funds, fees can spiral upward. For example, VC giant Andreessen Horowitz earns hundreds of millions of dollars in management fees.
2. Other fees paid by the fund
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 debt. 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 or syndication wouldn’t have all of these fees. But some do…
We suggest GPs clearly disclose these affiliated fees in their fund’s documents.
3. Carried interest
This is the big one!
A GP’s carried interest (also called “promote” or “incentive income”) is its share of the profits.
This is different from “guaranteed” fees such as asset management or acquisition fees.
The GP should only get carried interest if the fund performs profitably.
How does the GP get carried interest?
Each investment fund or syndication has a section in its governing documents called Distributions. It’s usually somewhere in the middle of the document.
If the fund has money to distribute, the “Distributions” section determines how the cash is divided among the fund’s owners (the GP and the LPs).
You might hear this called the distribution waterfall.
What does a distribution waterfall look like?
In many funds, the GP gets somewhere around 20-30% of the fund’s profits.
A very simple distribution waterfall might look like this.
If there’s money to distribute:
- Step 1: The LPs get 100% of the money until they’ve received a return of their initial investment; and
- Step 2: The LPs get 80% of the profits and the GP gets 20%.
So, if LPs invest $100 and the fund returns $200:
- First, LPs would get $100 as a return of their capital; and
- Next, $80 would go to the LPs and $20 would go to the GP.
That $20 paid to the GP is its carried interest.
This is an example of a very basic distribution waterfall. Many waterfalls get much more complicated than this.
Preferred Returns
For example, some waterfalls have a preferred return where LPs get extra distributions before the GP starts earning carried interest.
An example might look something like this:
Step 1: 100% to the Limited Partners until they have received distributions equal to their capital contributions;
Step 2: 100% to the Limited Partners until they have received distributions equal to 8%, compounded annually, on their capital contributions; and
Step 3: 80% to the Limited Partners and 20% to the General Partner.
In short, preferred returns often result in more money going to LPs. Talk to your lawyer!
Where do you go from here?
As a professional athlete, you study the playbook, watch game film, and scout opponents. These same skills transfer over to your work as an LP or GP.
As an LP, you should study the distribution waterfalls presented to you, comparing one fund against the next. The waterfall is an element of the investment that should factor into your decision to invest.
As a GP, you need to understand your options and structure your fees around what will appeal to LPs.
Ultimately, both LPs and GPs benefit from a deep knowledge of fund fee structures. And when all else fails, call a lawyer! We know some 😉
About the Authors: Michael Huseby and Chris Schuering are securities attorneys. Michael is the founder of The Investments Lawyers, PLLC (“TIL”), where Chris is Counsel. At TIL, they focus on fund formation and securities laws, representing both investment managers (GPs) and capital providers (LPs).
Check out the law firm website at til.law.
They also run a newsletter at fundamentals.law where they explain how investment funds and syndications work.
