Pay To Play

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‘Tier 1’ funds have long benefitted from a self-reinforcing loop when it comes to their fundraising.

Take the example of venture capital: The best entrepreneurs want Tier 1 funds as investors in their start-ups, which in return generate the best returns for their funds - attracting not only other top-tier founders, but also making their fundraising efforts much easier.

For smaller LPs, let alone private individuals, it can be challenging to access such funds. But sometimes, a miracle happens: Someone in your network might’ve secured an allocation to a Tier 1 fund and is happy to syndicate some of his allocation to willing investors through an SPV, for a small fee, of course. Or the GP, who typically doesn’t let in investors with smaller tickets, offers you access through a special side fund - with a different fee structure.

At first glance, you might be tempted. After all, you’ve read many times (even in this newsletter) that Tier 1 fund returns are what makes manager risk worth it. But does that justify higher fees - and if so, to what extent?

Let’s highlight a few common pitfalls, and as always, let’s try to do the math ourselves.

Understanding the LP/GP Fee Model

You might’ve heard of 2/20 before. In a 2/20 fee model, a GP would typically receive 2% of the committed capital of a fund per year as management fee, and a 20% profit share of any upside after returning the invested capital to their LPs.

Typically is the key word here, as there are numerous variations and details of the LP/GP fee model that makes it very hard to generalize into two numbers and slash in between.

Differences in Management Fee

It is crucial to clarify on what the management fee is charged. The typical model is a fee on committed capital, i.e. the maximum amount you’re willing to invest in the fund. If you invested 1M€ to a fund with a 2% management fee on committed capital, your annual fee load over a 10-year term could be as a high as 10 years 2% 1M€ = 200K€.

But committed capital is not necessarily invested or paid-in capital. It’s not unusual for a fund to have an early exit, which could return 5% to 10% of the fund back to LPs. This capital might then be reinvested, resulting in the LP only having to pay in 90-95% of his commitment. However, in the case of management fee charged on committed capital, your fee load is the same euro amount - meaning that if they charged the full 200K€ on 900K€ invested capital, your fee load increases to 22,2%.

There’s also fee models charged on net asset value, meaning that the fee is not only charged on committed or invested capital, but also on the increase in value of underlying portfolio companies. 

And while it might not seem like it, the differences between those models are significant: Using my somewhat basic Private Equity 101 model from last year, we can see that our difference, each time using the same 2% management fee but the three different models, has an almost 10% difference in fund performance:

Differences in Carry

One key point that the 2/20 carry model doesn’t highlight is the terms underlying the 20% carried interest. First of all, GPs typically need to repay the management fee and other fund-level expenses charged to the LPs before they receive the carry. Assuming the 20% fee load, it would mean that an investor needs to generate a 100€/80€ = 25% return to get the LP to break-even.

There’s another important parameter: The so-called hurdle rate. The hurdle rate states the required return that a GP needs to generate on an LP’s invested capital before being eligible for carry. Especially today, as investors can generate low-risk, positive real returns (i.e. after inflation) again, they can rightfully expect GPs to first generate a market-appropriate return before being eligible for their carry.

Typically, this hurdle rate is set somewhere between 6% and 12% IRR (which is not equal to the market’s annual return, as we recently discussed). Recently, I’ve also seen more absolute, multiple-based hurdles, i.e. carry being payable after investors receive a 1,3-1,5x cash-on-cash return. Yet some high-flying GPs might not have a hurdle rate at all, meaning that they profit from the moment their fund is ‘in the money’.

But even then, carry does not equal carry, especially when it comes to top-tier funds.

First, whether carry is charged on a deal- or fund-level basis. Typically, we see what is called a European waterfall. Waterfall, in this case, describes the fund flow by which GPs and LPs receive their part of a fund’s proceeds. With a European waterfall, only receives carry after LPs have received returns in excess of invested capital and the hurdle rate. With an American waterfall, GPs receive carry on a deal-by-deal-basis, meaning that the GP are eligible to receive carry on individual, return-generating deals even before the LPs have received their money back. 

Second, the size of the carry. Typically, successful funds try to focus on larger LP tickets rather than gather individual, small tickets from high-net worth individuals. But there’s also some that go the other way. Remember my example in the introduction of successful GPs that allow smaller LPs to invest at different fee terms. Different might be a slightly higher management fee and carry burden (i.e. 2,5% and 22%), or a one-off onboarding fee of 1-5%.

But it can also mean more extreme models. I remember meeting a GP who proudly told me that they’d happily take ‘minimum tickets’ (200K€ for semi-professional investors in Germany), but that at that size, they’d charge 0/75 - so no management fee, but 75% of all upside generated by the fund beyond a modest hurdle rate. Of course, offering such a model is a sign of confidence to LPs, as not generating returns would mean that the GP leaves empty-handed. But it also meant that LPs would essentially grant the GP almost-free, non-recourse leverage. Despite outstanding gross returns, we decided to rather go with an equally well-performing GP with a more regular fee model.

And lastly, so-called ‘supercarry’. In a supercarry model, GPs receive an additional step-up in their carry beyond a certain cash-on-cash return. For example, an GP might charge the regular 20% carry to a 3,0x net multiple, which would then step up to 30% for returns in excess of this 3,0x multiple. Besides the obvious increase in fee burden, I find supercarry to be a negative indicator. There’s many incredibly successful firms out there built on the traditional 2/20 models, so raising the fee burden on LPs, especially when it’s done by a young GP (think Fund II / III) to be, is a sign of arrogance rather than long-term orientation.

Feeder Fund Fees

Some funds might be hard for you to access directly, so you might consider investing through a so-called feeder fund. In most cases, feeder funds don’t do this for free: At the very least, they pass on the fees of the feeder vehicle to investors; more often, they charge a small yet notable, ongoing management fee to make it worth their while. There might also be a one-off “access fee” and/or a carry for the feeder vehicle itself.

On the matter of feeder funds, let’s take an example, loosely based on some of the opportunities we were shown in 2021/2022. 

Imagine that someone raises a $100M feeder fund intended to invest into a Tier 1 fund. The underlying fund charges a 2% fee on committed capital, as well as a 25% carry (with no hurdle rate). The feeder fund charges 1% p.a. and 10% carry. However, you did invest into a Tier 1 fund after all, which manages to generate a whopping 5x (!) return on their invested capital.

So the returns to you, as an investor, even after fees, must also be great - right?

Not quite: While a 5x return looks great, it's less great if management fees eat into how much can be invested to begin with. Given the 2% fund-level and 1% feeder-level management fee, only $90M is invested into the underlying fund, and only $72M is actually invested into companies. Thus, our net proceeds are not $500M but “only” $360M (3.6x net, or 5.0x gross on $72M). And that’s before carry: The fund takes 25% of the gains (25% * $270M = $68M) and the feeder fund takes another ~$20M, leaving us with total net proceeds of $273M, or 2,73x - far below our 5x headline results.

Had you instead invested directly in a fund with ‘regular’ terms (2/20, assuming no hurdle), their gross multiple could be ~20% lower (4,1x instead of 5x) and they would generate the same return. And that’s assuming that your Tier 1 fund does actually generate a 5x return: Often enough, unfortunately, feeder funds provide you access to one of their funds - but actually not their flagship fund, but their European, growth, or other “side” fund. Looking back today, the fund underlying this feeder fund is far away from the 5x return. It might even end up on the ‘bad end’ of venture capital’s performance dispersion.

What Fees Are Worth It?

One of my recent favorite quotes came from a podcast with Steve Edmundson of NPERS, who said that investors should be razor-focused on reducing fees as that’s the one part of the investing equation (the other one being market performance) that we can actually control. And this applies equally to alternative investments: LPs should always try to reduce their fee load. But of course, things are often more nuanced - while the cheapest instrument (i.e. an ETF) might be the best choice for public markets, the same doesn’t necessarily translate to private markets.

So what fees are worth it, and which ones are not?

Management Fee: The management fee should be seen in light of the fund size and maturity. Typically, the larger the fund, the more LP-friendly the fee model, as larger LPs put pressure on the GP to reduce their ‘risk-free’ management fee revenues. For smaller funds, LPs should pay attention to the size of the management fee: I typically would stay away from fee models that have a fee load in excess of the 20%, but I would also make sure that the overall fee load is warranted - a GP shouldn’t enrich themselves with the management fee, no matter the size.

Carry: I would make sure that carry isn’t in excess of 20%, or for an outstanding GP, in excess of 30%. I would not invest in “0/75” models unless I am extremely downside-oriented, as I’ve yet to find a strategy in which I can’t find an alternative GP with a more appropriate fee model. I always ensure that the hurdle rate is appropriate (in the 6-12% range), especially in today’s day and age where I can earn ‘risk-less’ profits again. Lastly, as I mentioned before, I also try to stay away from supercarry structures.

Feeder Fees: In my career, I was lucky enough that our ticket sizes were typically large enough to network our way directly into a GP’s main fund. However, not everyone is lucky enough to be able to write such big tickets. If you have to rely on feeder funds, try to find those that offer the lowest fees. In some cases, it might even make sense to forego individual feeder funds and instead go for a fund of funds, as I personally find some of those be less affected by adverse selection - a fund of funds might have better underlying funds through the long-term relationships they build and the value-add they offer, as opposed to a feeder fund that might ‘just’ bring them capital.

You can also try to network your way into the fund despite a small ticket. If you are an entrepreneur or a family office with a special skill set, you can also try pitching that to the GP and offer your assistance, as sometimes that might allow you to invest in their ‘friends & family’ fund at the regular fee load. But beware: Once again, letting you in as a small LP might also be a sign of adverse selection, as it might mean that they struggle raising capital from larger LPs.

As everywhere in life, there is no definite rule on what fee models are good and which are bad. LPs should always see them in light of the overall fund investment, especially in regards to the underlying performance. While I would generally not invest in funds with the 0/75 model, I would definitely consider a Tier 1 fund at a just slightly more expensive fund model, i.e. 2/25 or 2/30. As mentioned before, feeder funds or funds of funds can also make sense in certain cases for large and small LPs alike. A good exercise is comparing the gross-net spread, i.e. checking performance before and after fees, and making sure that it matches the communicated terms.

And of course, there’s a lot more creative ideas when it comes to reducing your fee load. It’s things such as networking your way into a fund, but it’s also factors such as no-fee co-investments. But those are topics for another time.

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