Permian | Compensation / Fees
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Compensation / Fees

COMPENSATION / FEES

These terms are explained from a general financial point of view, but also with a more particular relationship to the private equity fund industry.

Advisory fee, Management fee, General Partner’s Share

Strictly speaking, Advisory Fee is paid for advice received from a consultant or a fund manager, while a Management Fee or General Partner’s Share is received for taking on a responsibility to act on behalf of another, typically a fund entity. The fund entity may be set up in such a way that it does not in itself have a “legal personality”, it is not set up to act in its own name. In jurisdictions like Jersey or Guernsey, the funds are often Limited Partnerships which are acting through a General Partner (No. Indre Selskap eller Kommandittselskap som virker ved henholdsvis Hovedmann og Komplementar).

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The distinction between Advisor and Manager may not always be clear and the “Advisor” may have such authority that the term management fee would be more appropriate.

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The Management fee and General Partner’s Share typically changes over time. The final fee structure is often a result of negotiations between the managers/General partners and the investors during the fund raising period. The better track record the stronger the position of the General Partner, but it is common to find some sort of mechanism which reduces the fee over time and/or corresponding to the value of the portfolio.

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Fees collected by the General Partner from third parties, as a result of conducting the business of the fund, e.g. transaction fees, finders fees, co-investment fees and underwriting fees, are typically deducted from the General Partner’s Share.

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In Norway, Managing a fund is a service which is VAT exempt while giving financial advice is not. This is important as most investment companies will not be VAT registered and therefore will not be able to recover VAT.

Carried Interest

Carried interest is a term for an the extraordinary profit element due to the General Partner if the performance of the fund exceeds a certain annual return, often termed the Hurdle Rate. The carry element will typically be in the region of 10 – 30 % of the return above the Hurdle Rate, and is in disproportion to the amount the GP has invested in the fund.

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Commonly, Carried Interest is calculated based on total fund performance. This is the most LP friendly scheme and Carried Interest is not paid until the amount paid-in to the fund and the Hurdle Rate element have been distributed to the investors.

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The most GP friendly scheme on the other hand is a strict “deal by deal” Carried Interest under which the General Partner would receive carry following the successful realisation of one investment even though the remaining portfolio at that time may have a value which if realised would represent losses for the investors. A number of intermediate solutions exist, all designed to balance GP motivation and LP return.

Catch-Up

The term is perhaps most easily explained with an example. The fund invest 100, one year later 110 is realised. The fund has an 8 % hurdle clause and 20 % carry.

 

Without catch-up the LP will receive the original 100 invested + 8 being the agreed hurdle and 80 % of the remaining 2, in total 109,6. The GP will receive carry, 20 % of the 2 being 0.4.

 

With full catch-up the LP will receive the original 100 invested + 8 being the agreed hurdle. The remaining 2 will go to the GP, the result being that the full return of 10 has been split 80/20 between the GP and the LP. By skewing the distribution, following the distribution of hurdle to the Limited Partner, in favour of the General Partner, the General Partner has «caught-up» with the Limited Partner as far as return is concerned.

Clawback

The Clawback terms of the LPA describes the process and terms under which the fund may recover money which have been paid to the General Partner. The reason for such recovery is typically that some event has occurred which reduces the performance of the fund compared to what has previously been used as a basis for paying carried interest or management fees.

 

A number of issues to pay attention to regarding clawback provisions:
– The GP may have paid tax on the amounts received – unrecoverable tax is normally not subject to clawback.
– How do you deal with clawback when the fund has made distributions in-kind?
– How do you deal with clawback following ownership changes in the fund?

Hurdle Rate

The hurdle rate is a minimum rate of annual return on net capital paid into the fund, which is due to the investor before the General Partner may have a right to Carried Interest. In other words, if the performance of the fund falls below the hurdle rate, there will be no Carried Interest to the General Partner.

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The market standard is a Hurdle Rate of 8 %, but rates from 5 – 12 % may occur. In theory, the Hurdle Rate should be lower in periods of low interest rates and vice versa. In practice the level has been remarkably stable. In this regard, it is important to note that the fund’s lifetime is typically 10-15 years and the level of interest rates will fluctuate over time.

Subscription Fee

A subscription fee is a fee charged at the time of subscription to the fund, payable at first Close. It is typically calculated based on Committed Capital to the fund and is used to cover the establishment costs of the fund. The size of the fee tend to be dependent on the expected size of the fund as establishment costs are not necessarily linearly related to the amount of Committed .

Transaction Fees

Fees directly referable to the making of an Investment.

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The Limited Partnership Agreement will typically include a provision that any Transaction Fees received by the Investment Advisor or General Partner, from a third party, related to a transaction of the fund, should be deducted from the Advisory fee for the period.

Underwriting Fees

Underwriting fees is collected by banks, financial institutions, private equity funds etc. from having “guaranteed” the sale of eg. a new issue of shares in a certain number and at an agreed offer price. If the market does not subscribe to the shares in sufficient numbers, the underwriter is obliged to purchasing the shares.

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The Limited Partnership Agreement will typically include a provision that any Underwriting Fees received by the Investment Advisor or General Partner, from a third party, related to the commitment of the fund’s assets, should be deducted from the Underwriting fee for the period.

Waterfall

In private equity, the term waterfall refers to the distribution mechanism. The waterfall clause in the Limited Partnership Agreement states who shall receive the first money to be distributed and so on – until all the fund’s assets have been distributed and the fund closed.

 

A typical waterfall clause states that after all costs are covered, first in line for distributions up to the amount paid into the fund, are the Limited Partners and the GP in the role of investor. Secondly, assuming there are funds available, the Limited Partner and GP as investor, will receive the Hurdle rate return. If the LPA has a Catch-Up mechanism, then this follows, before finally the remaining assets, as realised and distributed, are divided between the LPs and the GP as recipient of Carried Interest (see Carried Interest).

 

The waterfall mechanism may be complicated by various clauses addressing the element of time. The General Partner wish to be able to receive carried interest as early as possible, and the Limited Partners may have accepted this under certain conditions. The conditions typically include escrow and clawback stipulations, obliging the General Partner to return all or parts of such early distributions if the performance of the fund is negatively impacted by later events.