Fund economics: traditional and evolving approaches
By Abdullah Mutawi, Partner and Fawaz Elmalki, Senior Counsel
Benjamin Franklin famously once wrote that “nothing can be said to be certain, except death and taxes” - although if you have ever been an investor in a private equity, venture capital or hedge fund, you could be mistaken for believing that the basis for compensating fund managers was about as certain as death and taxes.
For almost all investors in managed funds, private equity, venture capital and hedge fund strategies are a grouping of asset classes to which they look for portfolio diversification and outsized returns compared to the more traditional public equities investments (stocks, ETFs, mutual funds) and fixed income products (government treasury bonds, corporate bonds, etc) which are regarded as more conservative, and which usually make up the bulk of an investor’s asset allocation strategy. This is why private equity (PE), venture capital (VC) and hedge funds are sometimes referred to, along with real estate, as ‘alternative’ investments.
Unlike traditional asset classes, alternative investments (save for many hedge funds) are typically illiquid and, because investors expect alternatives to deliver outsized returns, they typically want to place their cash with fund managers who have a demonstrable track record of success and preferably ‘skin in the game’.
In other words, if an investor is going to place their cash in the hands of someone who will deploy it into risky and illiquid asset classes, the incentive structure for the fund manager cannot simply be a generous corporate salary that the fund manager gets paid regardless of whether their investments succeed or fail. Incentives must be aligned.
In the world of alternative investments, investors have an enormous range of funds and fund managers to choose from when deciding where to allocate that portion of their cash investments. Over the past few decades, several huge firms have emerged across the different alternative investment categories, raising and managing hundreds of billions of dollars of aggregated ‘assets under management’ (or AUM) across multiple funds and multiple strategies.
At the other end of the spectrum are first-time fund managers with no AUM setting out to establish their very first fund. And of course, there are hundreds of players that sit somewhere in between these two ends of the AUM spectrum. Fund managers are judged on historical performance with well-established metrics and criteria, effectively scoring fund managers on the likelihood of future success.
The ‘two-and-twenty’ compensation model
Given the abundance of fund managers to choose from, one would expect to see a competitive landscape when it comes to fund manager compensation. And yet, the global market standard often referred to as the ‘two-and-twenty’ fee structure is the essence of how fund managers are universally paid for their services. Inevitably there are nuances to how this principle is applied in practice but ‘two-and-twenty’ is the dominant fee structure across alternative assets regardless of where in the AUM or maturity spectrum the fund manager sits.
In essence, the structure works as follows:
2% management fee:
Typically calculated on fund capital and charged to the fund’s investors annually during each year of the fund. In a PE or VC fund, the management fee is usually charged on committed capital during the commitment period and on invested capital, often with a step-down in the fees, thereafter. In a hedge fund, the management fee is charged on the fund’s net asset value. The management fee covers the ongoing operating expenses of the fund manager, including office rent, business equipment, logistical expenses and team salaries.
20% performance fee:
Otherwise referred to as 'carried interest' in a PE or VC fund, this is a share of the profits of the fund payable after the return of the original capital to the investors. In a hedge fund, this fee is also referred to as an incentive fee and is payable on an increase of the net asset value of the fund.
There can be variations to how management fees are applied. When it comes to carried interest, there is almost always a ‘hurdle rate’ which is a preferred return that must also be paid to the investors before any carry is paid to the general partner (GP).
A hedge fund will also include a hurdle rate and a high-water mark which is a mechanism to ensure that performance fees are only paid on new profits generated by the manager. Carried interest is also typically subject to catch-up provisions and claw-back provisions depending on the specifics of each fund. It is also expected that the GP/manager will commit some capital to the fund as a sign that its key individuals have conviction in their own strategy and are prepared to tie the fate of their own money to that of their LPs.
But, in spite of its almost universal application in the industry, the ‘two-and-twenty’ model presents inherent challenges to new and emerging PE and hedge fund managers. For example, a first-time PE fund manager will find it difficult to hire the talent required to manage a successful fund unless they have raised a sufficiently meaningful sum of capital commitments from LPs. This is required to be able to afford the kind of salaries, out of the 2% management fee, that would attract the kind of talent required. Given that a $50 million fund will attract an annual management fee, that would provide around $1 million per year, out of which salaries, rent and other operational expenses must be covered. This is not much to play with, and yet a first-time MENA manager in 2023 will find it very challenging to raise a $50 million fund.
The model only becomes truly compelling when a fund manager raises its second or third fund as the firm will, by that time, have accumulated sufficient AUM to generate a meaningful management fee based on 2% of committed/invested capital in the case of a PE fund.
But to raise a second or third fund, a PE firm needs to have the Distributed to Paid In Capital track record (commonly referred to as 'DPI') on its first or second funds to persuade investors to continue to back the firm and the team. So attracting solid talent into the first fund is very important. And the two-and-twenty model presents a chicken and egg situation there.
...if an investor is going to place their cash in the hands of someone who will deploy it into risky and illiquid asset classes, the incentive structure for the fund manager cannot simply be a generous corporate salary that the fund manager gets paid regardless of whether their investments succeed or fail. Incentives must be aligned.
Variations on the ‘two-and-twenty’ model
For more than a decade, the death of the ‘two-and-twenty’ model has been widely discussed in the hedge fund industry. Now that we have exited an era of PE and VC investing exuberance and entered a new period of economic uncertainty, we can also expect renewed pressure on the ‘two-and-twenty’ model in PE and VC funds. In the last 18 months or so, we have started to see increasing variations in the model in different markets including MENA. These can be driven by a range of factors including fund structure, fund strategy or the profile of investor(s) (single shareholder funds, corporate venture funds, single or multiple family office, etc).
In the MENA region, where local sovereign wealth funds (SWF) have emerged as active PE and VC investors, one example of such variation is the allocation of equity interests in start-up fund managers (or GP as the case may be) to the SWF in exchange for funding the related new fund as anchor investor. We have seen this done purely as an incentive to anchor a fund but also as a combination of incentive and equity interest for injected cash capital to the fund manager, which assists in funding the fund manager’s operating expenditure in the early days of the fund prior to (or sometimes alongside) the fund manager’s entitlement to be paid management fees.
Allocation of equity to an anchor investor also gives that investor access to the performance fee of the manager or GP (as the case may be) and, in effect, this serves as a discount (or, more accurately, a rebate) on the carry charged to that investor against fund returns over and above principal capital. SWF support for new managers is in line with a rising number of emerging manager programmes globally. These programmes, which are increasingly coupled with a diversity and inclusion objective, identify promising managers who need capital to build an investment track record and may also provide operational support.
Even with PE and VC fundraising slowing down globally, mega funds by top tier managers will still be able to attract SWF and large pension fund interest, however super carry interest fees (30%) are unlikely to be an acceptable term. However, these higher carried interest fees, on a zero-and-thirty basis (no management fees), may still be aligned with investors’ interests in certain circumstances where managers with a shorter-tenor strategy are looking to deploy and generate exits on an expedited basis. For example, a warehoused pipeline of deals or a strategy of investing in distressed secondaries.
In corporate venture fund and single-shareholder fund models, the carry percentage is highly variable and there are a number of reasons why the GP’s management team can operate on significantly less than a 2% management fee and other instances where 2% is materially insufficient.
For example:
A corporate venture capital fund
A corporate venture capital fund may have a significant allocation of capital and may benefit from a much deeper bench of well-compensated executive talent than a typical fund manager. That talent pool may be employed and/or compensated by the corporate ‘parent’ and can service the investment strategy in a more executive and strategic way. In such entities, the sole investor (or shareholder) may also likely see the fund as a captive and strategic investment arm rather than a purely asset-management play where interests have to be aligned, such as a manager investing third-party capital. In those situations, it is not unusual to see carried interest as low as 8% or 10% and for management fees to be lower than 2%. In some cases, there may be no management fee as such but rather a budgeted OpEx in the business plan which takes account of the specifics of the situation.
Single-investor manager of a relatively small pool of funds
On the other hand, a single-investor manager of a relatively small pool of funds in a complex strategy, may not be able to attract the talent required with only a 2% management fee. For example, a family office looking to allocate $20 million to a manager deploying into early-stage VC opportunities will require a substantially greater budget than $400,000 to cover annual operating expenses. Variations on the two-and-twenty model are therefore structured on a bespoke basis.
Carried interest structures
We typically see four distinct approaches to carried interest in closed-ended funds waterfall clauses.
US-style carry on a 'deal-by-deal' basis
Carried interest is determined and paid to the GP on each individual deal. The key advantage of this approach is accelerated payments of carried interest. The GP can start to receive carried interest from the proceeds of a realised investment as soon as the capital contributions by the investors for that investment are repaid to the investors.
The key disadvantage for investors is that this carry structure may pay out on one good investment even if many of the other investments don't perform, therefore it is critical to build in claw-back mechanics to prevent an overall overpayment of carried interest to the GP. Pure deal-by-deal structures are rare, but with certain amendments, as described below, still serve as the model for many US managers.
'Modified' or 'hybrid' deal-by-deal
These are variations to the pure deal-by-deal model and are widely adopted by GPs globally. Basically, modified or hybrid waterfall provisions aim for the GP to share in losses incurred by the fund on an ongoing basis and for investors to recover a larger share of their contributed capital prior to any carried interest being paid to the GP.
Investments that are written off or written down suppress the payout of carried interest on successful investments. In addition, the GP may be required to return all or a portion of the fees and expenses incurred by the fund before payment of carry. There are numerous iterations of the deal-by-deal model which could be more or less investor friendly.
UK and EU-style 'whole fund' carry
This is the easiest to administer and, in essence, provides that the investors get all the invested money back (plus the preferred return) before the carried interest pays out. The GP often then receives a 'catch-up' equal to the carry percentage of the preferred return before further proceeds are split between the investors and the team, typically 80:20, but not always. Due to the delayed compensation to the GP, this type of waterfall may cause challenges in attracting senior staff.
A bespoke variant of 'whole fund' carry
For example, instead of calculating carry on all investments by treating them as investments by a single fund, establishing vintages or thematic pools (eg all investments in a particular deployment year or all investments in a specific vertical). This type of carry payment can be facilitated through the establishment of a segregated portfolio company or a multi-class limited partnership.
Conclusion
Closed-ended fund waterfall arrangements can be complex and have nuances which require careful consideration by both investors and managers.
If you have any questions about fund structuring, our newly launched Funds practice can help guide you through the process and the accepted market practices whether you are establishing your fund in MENA or in many of the most commonly selected offshore jurisdictions. Please don’t hesitate to reach out to us.
