Creative solutions around fees can help private capital managers stand out in a tough environment, say Harriet Miller and Jade Allman of Macfarlanes.
The private capital market has become increasingly competitive in recent years and managers are having to think creatively to stand out in a unpredictable macroeconomic and geopolitical environment. This article will examine some of the creative solutions that managers are offering to meet changing investor demands, and the challenges faced in doing so.
Whenever an industry sees increased competition, this typically results in downward fee pressure. A trend seen across all private fund asset classes and requiring managers to offer more elaborate fee discounts. Initially, it took the form of a “first close” discount which has subsequently evolved into an “early bird” discount (in some cases being offered on a ratcheted basis to investors admitted up to 12 months post-first close).
However, fee discounts are now not only being linked to the timing of admission, but managers are also seeking to create loyalty and engagement from investors across multiple strategies. For example: offering discounts to investors in an earlier vintage of a fund, or across multiple strategies and funds within the manager’s group; or linking the fee rate to certain targets or returns being met, whether in respect of a single fund or a blended target rate across multiple strategies.
‘Most favoured nations’
As a result, there are more investors enjoying fee discounts. A manager will need to be sufficiently large to offer increased fee discounts without it impacting their operations. It is therefore more common to see such fee discounts offered by managers with more than £500 million in assets under management and operating within multiple strategies (e.g. credit). Care also needs to be taken that any fee discounts do not subsequently have to be offered to investors under any ‘most favoured nation’ (MFN) arrangements. This is particularly important for multi-strategy managers.
managers are naturally questioning if it is financially viable to keep giving such investments away for free.
To further help investors reduce fees, there is growing demand for access to fee- and carried interest-free co-investment. Investors are becoming more sophisticated with their internal deal doing capabilities and recognise that any such fee- and carried interest-free co-investment helps reduce the overall fees paid to a manager on a blended rate. The market terms for co-investment continues to be on a minimal-fee and zero carried-interest basis unless the asset is deemed exceptional. As significant co-investment continues to be offered and (in some cases, noteworthy) returns are being delivered to investors without any deduction of carried interest, managers are naturally questioning if it is financially viable to keep giving such investments away for free.
This is especially true in the recent poor fundraising environment, if the flagship fund does not close at the size the manager had initially targeted. The manager bears operational costs regardless of the fund size for which they need to receive fees, and if carried interest is being given away, managers must continue to attract and retain talent. To counteract this, some managers are offering co-investment vehicles from day one alongside the flagship fund, rather than once the main fund has started investing. This allows a manager to charge a reduced fee (so on a blended rate with the flagship fund, investors are still getting a discount) and carried interest.
Fee solutions are not the only creative solutions being offered by managers. New solutions continue to involve daily, such as: higher or different floating rate hurdles, or even offering a performance fee model (instead of a carried-interest model), which has been largely driven by investors wanting returns to embed rising interest rates; and rolling investment returns between funds and/or vintages, or the use continuation funds, both of which are seeking to address recent liquidity issues.
*Harriet Miller is a partner and Jade Allman is an associate in the private funds division of Macfarlanes law firm.
