In our 2017 research, we reported that the most prevalent rate of management fee charged (measured both by the number of funds and by capital raised) was 2% per year.

After another bumper year of fundraising, 2% remains the most commonly seen headline fee level, but more detailed analysis indicates that there is much more differentiation in the fee percentage ultimately charged. This variation is primarily driven by the size of the fund being raised.

More than 40% of the funds sampled charged a management fee in the range of 1.76% to 2%, with the overwhelming majority of these charging 2%. Two-thirds of the funds in the 1.76 to 2% bracket were buyout funds.

However, there are signs that 2% is losing prominence as the market standard. The 2% fee applied to the majority of the targeted capital in the 2017 survey, but only 8% of the targeted capital in the 2018 survey.

Whilst only 19% of the funds in this year's sample were charging a management fee of 1.5%, the aggregate amount of capital targeted by these funds represented 59% of the capital targeted by the entire sample. This is understandable given the increased scrutiny from investors on the management fees charged by larger funds and considering that multi-billion USD/EUR funds develop economies of scale that make a 2% annual charge unnecessary.

Strategies such as venture capital and growth capital that tend to produce smaller fund sizes also tend to have larger management fee levels, but this is driven more by the size of the fund than by the investment strategy it employs. Most venture funds (and all of the growth capital funds) in our sample charged an annual management fee of at least 1.75%.

Fee discounts

In practice, it can be complicated to identify the ultimate management fee rate. Almost a quarter of the funds in this 2018 survey implemented fee discounts in their LPAs for certain categories of investor.

The most popular trigger for a discount is the size of an investor's commitment. 54% of those funds offering a discount linked the discount to commitment size, either on its own or in combination with the investor being an "early bird" (i.e., subscribing at the fund's first closing). Nearly a quarter of the funds in the survey that granted management fee discounts gave their managers the flexibility to offer discounts to investors on an ad hoc basis.

Other managers charge a lower headline rate of management fee, but effectively increase fee income by charging an additional "administration fee", which usually applies across the life of the fund, or by charging additional fees for certain advisory or deal-related services. Additionally, a number of back-office services performed by the manager to the fund may also be charged separately "at arm's length" to the fund, as part of its operational costs, with a manager being thus additionally remunerated for operational or administrative services, on top of the fee for its investment and management expertise. It should be noted that there is growing pressure from investors for managers to reduce the amount of fees charged by the manager back to the fund.

Management fee after the investment period

Once the investment period expires, the vast majority of fund managers (87%) begin to receive a discounted management fee.

Most commonly, after the termination of the investment period, the management fee rate will remain the same, but the calculation basis of the fee will change.

From a calculation based on what the managers raised (total commitments) during the investment period, the fee rate starts accruing on what the managers put to work - the acquisition costs of the unrealised investments - as seen in 54% of the surveyed funds.

Occasionally, managers continue using the value of the commitments to the fund as the basis for the calculation of the management fee in the post-investment period. However, the fees are discounted by tapering the charged amount annually by reference to the amounts charged in the immediately preceding year.

MJ Hudson's PE Fund Terms Research 2018: Part I – Economics can be downloaded at https://www.mjhudson.com/private-equity-fund-terms-report-2018-part-i-economics/

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.