Before offering a fee break to investors, there are a variety of factors that a Private Equity firm must consider. Essentially, these boil down to 5 main considerations that broadly encompass the considerations needed:

1. Why?

2. To whom?

3. What type of fee break?

4. Impact on Fund?

5. Can the firm handle this?

   
   

Why?

The first question to ask is why do we want to offer a fee break to our investors? Depending on the size and performance of the firm, this could have multiple answers. 

1. One such answer could be that the firm wants to attract investors early. The firm could offer a management-fee break to those who invest in the first closing. So, those who invested in the first closing could get a break in the form of a reduction in management fees for the first year of the fund. This may not seem like much, but when you are dealing in millions or even billions, even one percent can go a long way. 

   
   

2. Another reason to offer a fee break is to reward repeat investors. Some private equity firms will reward investors who invest in subsequent funds or who have invested above a certain threshold on a cumulative basis.

   
   

3. The last reason to give a fee break would be to reward your biggest investors.  If an investor contributes above a certain amount, then you might reward them with a fee break to encourage the bigger investors.

   
   

To whom?

Next, your firm should decide who these fee breaks are geared towards. Most commonly, fee breaks are given to investors with high creditworthiness and high amounts of capital invested. This is due to the fact that these types of investors are usually less risky and provide the fund with a solid base of initial capital. After the fund has large, credit-sound investors secured, it generally becomes easier to find the last investors to complete the fund.  On the other hand, the fund could use fee breaks to attract early investors overall or even to appeal to specific types of investors such as pension funds.

What type of fee break?

Once you have narrowed down why you want to consider offering a fee break, the next question to answer is what type of fee break the firm would offer. The two main types of fees a Private Equity fund would charge are (i) management fees and (ii) performance fees. Typically, a management fee is calculated based on a percentage of the committed capital or invested capital of a fund. In the case of performance fees, these are a percentage of the fund’s overall profit paid to the GP. This performance fee is typically in the form of carried interest or promotion and is only distributed once the fund overcomes certain performance hurdles. When offering a fee break to investors, it is important to decide which fee you would like to provide a break on as different fee breaks have different calculations within the waterfall distribution.

Impact on the fund?

Another important consideration is the impact that the fee breaks would have on the fund. Providing a fee break to investors can improve the investor’s IRR since more distributions are flowing right into their pockets from inception. The fee break would narrow the gross to net spread to the investors. Thus, investors who have a positive experience, and more importantly a positive return, are more likely to invest with the fund in the future. However, providing fee breaks to investors takes away earnings for the GP’s of the fund which the GP uses to retain top talent to execute the business plans of the investments. For this reason, it is always important to balance the impact of fee breaks on your investors and the GPs.

Can the firm handle fee breaks?

Finally, if your firm decides they want to continue to pursue offering a fee break, the next thing to consider is if your firm can handle the individual calculations of fee breaks. When providing fee breaks to investors, the exemption of fees creates differences in the distribution waterfall calculation to each investor. For instance, if you offered the first 5 investors in a fund a one-time 1.5% reduction in performance fees and the next 10 investors a one-time 1% reduction in performance fees, these would result in different waterfall distributions. Or if you offered the first 5 investors in a fund a 1% reduction in performance fees for the next 5 years and the next 10 investors a 1% reduction in performance fees for the next 3, these have very different calculations. Thus, you want to be sure that your firm has the capabilities and bandwidth to calculate, certify, and manage individual waterfalls properly. If not, the firm should consider hiring an outside firm, such as 3E Management (www.3emanagment.org), to assist with the tracking and certification of individual waterfalls.

Before founding 3E in 2016, Managing Member Eric Bergin was Director at Rockpoint Group, where he was responsible for for the Finance Group, as well as acquisitions, asset management, and investor reporting activities.