Management Fees Under Pressure? Learn How Smart PE and VC Firms Overcome the Challenge with Technology
2023-02-15
Over the past decade, many private equity and venture capital firms have built incredible fortunes. A large amount of the money they’ve made has been through investments in companies that have outperformed expectations. However, a significant portion of gained wealth can be further attributed to management fees that quickly added up as fund sizes mushroomed to unprecedented levels.
Complex, onerous and opaque: these are several words that are often associated with such fees. For prospective investors, the management fees and carried interest charged by general partner fund managers can be a turnoff; but, historically, demand for private market opportunities meant that investors had little leverage over the fees. Now, though, given current marketing conditions, we’re witnessing the pendulum swing back in favor of limited partner investors.
Since the private market landscape has changed considerably over the past year, what happens now? Will the industry’s limited partners—the “money behind the money”—demand better terms from fund managers, just as venture capital (VC) and private equity (PE) firms are now making greater demands on startup founders and the companies that they invest in (or acquire)?
If ever there was a moment for the people that fund private market firms to use their leverage and push back, now would seem to be the time. So how can smart firms overcome the challenges that investors present to their fees? This article explores how the wisest among them are leveraging technology to deflate the pressure put on their management fees.
Setting the Stage: Private Market Funds and Concerns Around Management Fees
Private market funds are generally structured as limited partnerships. The manager of the fund is called the general partner (GP) and the investors that commit money to the fund are called limited partners (LPs). The GP invests the fund’s capital, manages the portfolio of investments, and executes exit events. LPs are passive investors who receive distributions from the fund.
In September 2022, Preqin published the results of its institutional investor survey, which focused on private fund fee terms and conditions. The survey results showed that transparency around fees, rather than the amount of fees charged, were of primary concern. Of the institutional investors surveyed, 59% indicated that transparency at the fund level required improvement, while 80% noted they have either frequently or occasionally decided not to invest in a private fund, due to the proposed terms and conditions. Therein lies the rub and the confluence of factors that have put firms’ management fees under greater pressure—investors’ lack of trust surrounding the fees, their enhanced leverage to seek better fee structures, and an economic climate that has led them to be increasingly selective when choosing which funds to invest in.
Private Equity Management Fees Under Pressure
Historically, private equity funds have a similar fee structure to that of hedge funds, typically consisting of a management fee and a performance fee, whereby most firms have a two-and-twenty fee structure. Under this paradigm, fund investors pay 2% per year of assets under management (AUM) plus 20% of returns generated above a certain threshold known as the hurdle rate.
When considering the management fee in relation to the size of some funds, the lucrative nature of the private equity industry is obvious. A $2 billion fund charging a 2% management fee results in the firm earning $40 million every year, regardless of whether it is successful in generating a profit for investors. Particularly among larger funds, situations can arise where the management fee earnings exceed the performance-based earnings, raising concerns that managers are overly rewarded, despite mediocre investing results.
Just as the lucrative nature of the industry is obvious, it logically follows that LPs may be predisposed to search for better fee terms in the current economic climate. And, of course, the recent COVID-19 pandemic only accelerated that pace of challenges that fund managers already faced: ongoing fee compression, heightened compliance and regulatory changes (discussed in detail below) and limited organic asset growth. Indeed, in this market cycle, the relationship power appears to be shifting back to LPs, often resulting in fee discounts and/ or more LP-friendly terms.
VC Firms Face Challenges and Are Lowering Their Fees, Too
Venture investors saw a reshaped landscape over the past year. Both the startup fundraising market and VCs’ own ability to raise new funds were turned upside down after a banner 2021 in which easy money was the overarching theme, coupled with surging investments in crypto companies and the broader blockchain landscape.
In this realm, we’re also witnessing the paradigm change in favor of LPs. For example, Sequoia Capital lowered management fees in its two recently launched venture funds, as it braced for a slower investment environment. The changes in fee structure, outlined to investors in December, allow LPs who committed capital to Sequoia's crypto and ecosystem funds launched early last year to pay management fees based on capital deployed, rather than the common model of capital under management that applies to other Sequoia funds.
The move marks an unusual concession by one of the world’s top venture investors after U.S. venture capital deals fell from their 2021 peak by 31%. Sequoia's longstanding relations with LPs has been tested by crumbling valuations in tech companies and the fallout in its portfolio company FTX.
Drawing the Ire of Regulators
What’s more, in the U.S., all signs now indicate that private funds will continue to be under a greater regulatory microscope. When the Securities and Exchange Commission (SEC) announced its 2022 examination priorities last March, it explained that it intended to focus on funds’ “… fees and expenses, custody, fund audits, valuation, conflicts of interest, [and] disclosures of investment risks,” among other things. More recently, on February 7, 2023, the SEC’s Division of Examinations reaffirmed that the “calculation and allocation of fees and expenses, including the calculation of … management fees and the impact of valuation practices …” would remain a focus area.
In years past, private funds have had minimal regulatory oversight because their investors were mostly high-net-worth individuals who were better able to sustain losses in adverse situations and, therefore, they received less protection. Recently, however, some private funds have seen more of their investment capital coming from pension funds and endowments.
As leading law firm, Kirkland & Ellis, advised: “In this environment, private funds should make sure they have top-notch controls and … invest in their compliance programs.” In fact, we expect the SEC’s Division of Enforcement to continue to pursue more enforcement actions against the private fund industry throughout 2023. Another leading law firm, Akin Gump, has noted that private fund managers should consider the following lessons from recent enforcement actions:
Fund managers should continually monitor disclosures, especially regarding fees and expenses, ESG and conflicts of interest to make sure their disclosures are in step with actual practices.
The SEC also appears to have brought back the “broken windows” approach to enforcement actions involving non-scienter based rule violations such as the pay-to-play, custody and proxy voting rules, as well as Regulation M. Private fund managers should consider revisiting their policies and procedures in these areas and incorporating them into training modules and annual compliance reviews.
Related to the “broken windows” theme, the SEC appears to be actively investigating whether private fund managers have sufficient electronic communications procedures to satisfy their books and records obligations under the Advisers Act. Now is a good time to assess your electronic communications policies and emphasize the importance of compliance, including to senior personnel.
Insider trading continues to be a top enforcement priority where the SEC is willing to push the envelope, especially in cases involving “bad optics.” Private fund managers should continue to focus on insider trading training for investment personnel and ensure they have strong surveillance measures in place to mitigate this risk.
The SEC continues to bolster its oversight of the markets for cryptocurrency and other digital assets.
Technology to the Rescue
If 2023 hasn’t become ‘the year of the bottom line,’ then I don’t know what else it could be except, perhaps, ‘the year that smart firms doubled-down on technology’ to deliver a competitive edge. As both regulators and LPs tighten the figurative screws on private capital firms, leading fund managers have realized that harnessing the power of key emerging technologies is essential if they wish to thrive.
One of their biggest challenges on their horizon is the deluge of data that they face on two fronts: external investment and internal administration. On the external side, firms have to analyze increasing volumes of data to make better decisions about selecting potential portfolio companies. On the internal side, they must also contend with the growing need to provide an increasingly expansive array of data to investors, regulators and other stakeholders.
Despite mounting data pressures, some laggard firms continue to rely on manual processes and archaic spreadsheets to run the back office and their broader operations. But, when the cost of this approach is quantified, the resulting figures are eye-opening for fund managers and further summon the need to adopt purpose-built platform technology that can help them increase operational efficiencies, reduce costs and hasten time to revenue.
Now, candidly, gathering and analyzing private market data is not easy. But, in today’s market, having a platform that supports your data analytics strategy is no longer a “nice to have.” It’s absolutely required to drive business operations and digital transformation at your firm. For example, the use of Asset Class’ Private Capital Cloud data analysis functionality can yield a type of flywheel effect: the more data that is analyzed, the greater the opportunity to gain actionable insights and advantages in the investment lifecycle.
Imagine having one platform that not only helps you overcome your data challenges, but further digitizes the entire investment process—from onboarding investors to managing subscription documents, administering funds, delivering sound reporting, and beyond—in effect, the entire lifecycle of the investment experience. The outcomes: reduced resource overhead and related costs, streamlined (digitized) operations, and an integrated reporting and compliance framework that will keep investors happy and regulators off your back. So, if, indeed, your management fees do take a hit this year, the preceding outcomes can help alleviate some of the pain, as your firm is better positioned to capitalize on the eventual rebound of the economy.
Summary
Today, LPs are paying closer attention to both macroeconomic factors and the evolving management fee opportunities that are available to them—and your firm should, too. While it is unclear exactly when the economy will completely rebound, fund managers should be prepared for the fact that investors will push back on management fees with greater gusto in today’s market. Accordingly, private fund managers need to do some soul-searching and realize that the incredible management fees that they garnered a year ago may not be as handsome as what awaits them in the months to come.
Firms need to be true and convincing when it comes to their management fees and leverage the latest platform technology to give them a competitive edge. Those that do will be well-poised to harness the tailwinds that will accompany the rebounding economy in quarters to come.
Discover How Asset Class Can Help Your Team
Need help navigating the challenges that your firm’s management fees are facing and discovering the platform technology that’ll give your team an edge? This is exactly where our deep subject matter expertise lies. Today, the Asset Class Private Capital Cloud powers hundreds of VC & PE firms around the world. Discover how the platform can help make your financial firm - frictionless. Schedule a demo with one of our team members today.
Sources:
https://www.lexology.com/library/detail.aspx?g=6e30ea71-6a55-48fe-ac8d-e5b1478f4f34
Over the past decade, many private equity and venture capital firms have built incredible fortunes. A large amount of the money they’ve made has been through investments in companies that have outperformed expectations. However, a significant portion of gained wealth can be further attributed to management fees that quickly added up as fund sizes mushroomed to unprecedented levels.
Complex, onerous and opaque: these are several words that are often associated with such fees. For prospective investors, the management fees and carried interest charged by general partner fund managers can be a turnoff; but, historically, demand for private market opportunities meant that investors had little leverage over the fees. Now, though, given current marketing conditions, we’re witnessing the pendulum swing back in favor of limited partner investors.
Since the private market landscape has changed considerably over the past year, what happens now? Will the industry’s limited partners—the “money behind the money”—demand better terms from fund managers, just as venture capital (VC) and private equity (PE) firms are now making greater demands on startup founders and the companies that they invest in (or acquire)?
If ever there was a moment for the people that fund private market firms to use their leverage and push back, now would seem to be the time. So how can smart firms overcome the challenges that investors present to their fees? This article explores how the wisest among them are leveraging technology to deflate the pressure put on their management fees.
Setting the Stage: Private Market Funds and Concerns Around Management Fees
Private market funds are generally structured as limited partnerships. The manager of the fund is called the general partner (GP) and the investors that commit money to the fund are called limited partners (LPs). The GP invests the fund’s capital, manages the portfolio of investments, and executes exit events. LPs are passive investors who receive distributions from the fund.
In September 2022, Preqin published the results of its institutional investor survey, which focused on private fund fee terms and conditions. The survey results showed that transparency around fees, rather than the amount of fees charged, were of primary concern. Of the institutional investors surveyed, 59% indicated that transparency at the fund level required improvement, while 80% noted they have either frequently or occasionally decided not to invest in a private fund, due to the proposed terms and conditions. Therein lies the rub and the confluence of factors that have put firms’ management fees under greater pressure—investors’ lack of trust surrounding the fees, their enhanced leverage to seek better fee structures, and an economic climate that has led them to be increasingly selective when choosing which funds to invest in.
Private Equity Management Fees Under Pressure
Historically, private equity funds have a similar fee structure to that of hedge funds, typically consisting of a management fee and a performance fee, whereby most firms have a two-and-twenty fee structure. Under this paradigm, fund investors pay 2% per year of assets under management (AUM) plus 20% of returns generated above a certain threshold known as the hurdle rate.
When considering the management fee in relation to the size of some funds, the lucrative nature of the private equity industry is obvious. A $2 billion fund charging a 2% management fee results in the firm earning $40 million every year, regardless of whether it is successful in generating a profit for investors. Particularly among larger funds, situations can arise where the management fee earnings exceed the performance-based earnings, raising concerns that managers are overly rewarded, despite mediocre investing results.
Just as the lucrative nature of the industry is obvious, it logically follows that LPs may be predisposed to search for better fee terms in the current economic climate. And, of course, the recent COVID-19 pandemic only accelerated that pace of challenges that fund managers already faced: ongoing fee compression, heightened compliance and regulatory changes (discussed in detail below) and limited organic asset growth. Indeed, in this market cycle, the relationship power appears to be shifting back to LPs, often resulting in fee discounts and/ or more LP-friendly terms.
VC Firms Face Challenges and Are Lowering Their Fees, Too
Venture investors saw a reshaped landscape over the past year. Both the startup fundraising market and VCs’ own ability to raise new funds were turned upside down after a banner 2021 in which easy money was the overarching theme, coupled with surging investments in crypto companies and the broader blockchain landscape.
In this realm, we’re also witnessing the paradigm change in favor of LPs. For example, Sequoia Capital lowered management fees in its two recently launched venture funds, as it braced for a slower investment environment. The changes in fee structure, outlined to investors in December, allow LPs who committed capital to Sequoia's crypto and ecosystem funds launched early last year to pay management fees based on capital deployed, rather than the common model of capital under management that applies to other Sequoia funds.
The move marks an unusual concession by one of the world’s top venture investors after U.S. venture capital deals fell from their 2021 peak by 31%. Sequoia's longstanding relations with LPs has been tested by crumbling valuations in tech companies and the fallout in its portfolio company FTX.
Drawing the Ire of Regulators
What’s more, in the U.S., all signs now indicate that private funds will continue to be under a greater regulatory microscope. When the Securities and Exchange Commission (SEC) announced its 2022 examination priorities last March, it explained that it intended to focus on funds’ “… fees and expenses, custody, fund audits, valuation, conflicts of interest, [and] disclosures of investment risks,” among other things. More recently, on February 7, 2023, the SEC’s Division of Examinations reaffirmed that the “calculation and allocation of fees and expenses, including the calculation of … management fees and the impact of valuation practices …” would remain a focus area.
In years past, private funds have had minimal regulatory oversight because their investors were mostly high-net-worth individuals who were better able to sustain losses in adverse situations and, therefore, they received less protection. Recently, however, some private funds have seen more of their investment capital coming from pension funds and endowments.
As leading law firm, Kirkland & Ellis, advised: “In this environment, private funds should make sure they have top-notch controls and … invest in their compliance programs.” In fact, we expect the SEC’s Division of Enforcement to continue to pursue more enforcement actions against the private fund industry throughout 2023. Another leading law firm, Akin Gump, has noted that private fund managers should consider the following lessons from recent enforcement actions:
Fund managers should continually monitor disclosures, especially regarding fees and expenses, ESG and conflicts of interest to make sure their disclosures are in step with actual practices.
The SEC also appears to have brought back the “broken windows” approach to enforcement actions involving non-scienter based rule violations such as the pay-to-play, custody and proxy voting rules, as well as Regulation M. Private fund managers should consider revisiting their policies and procedures in these areas and incorporating them into training modules and annual compliance reviews.
Related to the “broken windows” theme, the SEC appears to be actively investigating whether private fund managers have sufficient electronic communications procedures to satisfy their books and records obligations under the Advisers Act. Now is a good time to assess your electronic communications policies and emphasize the importance of compliance, including to senior personnel.
Insider trading continues to be a top enforcement priority where the SEC is willing to push the envelope, especially in cases involving “bad optics.” Private fund managers should continue to focus on insider trading training for investment personnel and ensure they have strong surveillance measures in place to mitigate this risk.
The SEC continues to bolster its oversight of the markets for cryptocurrency and other digital assets.
Technology to the Rescue
If 2023 hasn’t become ‘the year of the bottom line,’ then I don’t know what else it could be except, perhaps, ‘the year that smart firms doubled-down on technology’ to deliver a competitive edge. As both regulators and LPs tighten the figurative screws on private capital firms, leading fund managers have realized that harnessing the power of key emerging technologies is essential if they wish to thrive.
One of their biggest challenges on their horizon is the deluge of data that they face on two fronts: external investment and internal administration. On the external side, firms have to analyze increasing volumes of data to make better decisions about selecting potential portfolio companies. On the internal side, they must also contend with the growing need to provide an increasingly expansive array of data to investors, regulators and other stakeholders.
Despite mounting data pressures, some laggard firms continue to rely on manual processes and archaic spreadsheets to run the back office and their broader operations. But, when the cost of this approach is quantified, the resulting figures are eye-opening for fund managers and further summon the need to adopt purpose-built platform technology that can help them increase operational efficiencies, reduce costs and hasten time to revenue.
Now, candidly, gathering and analyzing private market data is not easy. But, in today’s market, having a platform that supports your data analytics strategy is no longer a “nice to have.” It’s absolutely required to drive business operations and digital transformation at your firm. For example, the use of Asset Class’ Private Capital Cloud data analysis functionality can yield a type of flywheel effect: the more data that is analyzed, the greater the opportunity to gain actionable insights and advantages in the investment lifecycle.
Imagine having one platform that not only helps you overcome your data challenges, but further digitizes the entire investment process—from onboarding investors to managing subscription documents, administering funds, delivering sound reporting, and beyond—in effect, the entire lifecycle of the investment experience. The outcomes: reduced resource overhead and related costs, streamlined (digitized) operations, and an integrated reporting and compliance framework that will keep investors happy and regulators off your back. So, if, indeed, your management fees do take a hit this year, the preceding outcomes can help alleviate some of the pain, as your firm is better positioned to capitalize on the eventual rebound of the economy.
Summary
Today, LPs are paying closer attention to both macroeconomic factors and the evolving management fee opportunities that are available to them—and your firm should, too. While it is unclear exactly when the economy will completely rebound, fund managers should be prepared for the fact that investors will push back on management fees with greater gusto in today’s market. Accordingly, private fund managers need to do some soul-searching and realize that the incredible management fees that they garnered a year ago may not be as handsome as what awaits them in the months to come.
Firms need to be true and convincing when it comes to their management fees and leverage the latest platform technology to give them a competitive edge. Those that do will be well-poised to harness the tailwinds that will accompany the rebounding economy in quarters to come.
Discover How Asset Class Can Help Your Team
Need help navigating the challenges that your firm’s management fees are facing and discovering the platform technology that’ll give your team an edge? This is exactly where our deep subject matter expertise lies. Today, the Asset Class Private Capital Cloud powers hundreds of VC & PE firms around the world. Discover how the platform can help make your financial firm - frictionless. Schedule a demo with one of our team members today.
Sources:
https://www.lexology.com/library/detail.aspx?g=6e30ea71-6a55-48fe-ac8d-e5b1478f4f34
Over the past decade, many private equity and venture capital firms have built incredible fortunes. A large amount of the money they’ve made has been through investments in companies that have outperformed expectations. However, a significant portion of gained wealth can be further attributed to management fees that quickly added up as fund sizes mushroomed to unprecedented levels.
Complex, onerous and opaque: these are several words that are often associated with such fees. For prospective investors, the management fees and carried interest charged by general partner fund managers can be a turnoff; but, historically, demand for private market opportunities meant that investors had little leverage over the fees. Now, though, given current marketing conditions, we’re witnessing the pendulum swing back in favor of limited partner investors.
Since the private market landscape has changed considerably over the past year, what happens now? Will the industry’s limited partners—the “money behind the money”—demand better terms from fund managers, just as venture capital (VC) and private equity (PE) firms are now making greater demands on startup founders and the companies that they invest in (or acquire)?
If ever there was a moment for the people that fund private market firms to use their leverage and push back, now would seem to be the time. So how can smart firms overcome the challenges that investors present to their fees? This article explores how the wisest among them are leveraging technology to deflate the pressure put on their management fees.
Setting the Stage: Private Market Funds and Concerns Around Management Fees
Private market funds are generally structured as limited partnerships. The manager of the fund is called the general partner (GP) and the investors that commit money to the fund are called limited partners (LPs). The GP invests the fund’s capital, manages the portfolio of investments, and executes exit events. LPs are passive investors who receive distributions from the fund.
In September 2022, Preqin published the results of its institutional investor survey, which focused on private fund fee terms and conditions. The survey results showed that transparency around fees, rather than the amount of fees charged, were of primary concern. Of the institutional investors surveyed, 59% indicated that transparency at the fund level required improvement, while 80% noted they have either frequently or occasionally decided not to invest in a private fund, due to the proposed terms and conditions. Therein lies the rub and the confluence of factors that have put firms’ management fees under greater pressure—investors’ lack of trust surrounding the fees, their enhanced leverage to seek better fee structures, and an economic climate that has led them to be increasingly selective when choosing which funds to invest in.
Private Equity Management Fees Under Pressure
Historically, private equity funds have a similar fee structure to that of hedge funds, typically consisting of a management fee and a performance fee, whereby most firms have a two-and-twenty fee structure. Under this paradigm, fund investors pay 2% per year of assets under management (AUM) plus 20% of returns generated above a certain threshold known as the hurdle rate.
When considering the management fee in relation to the size of some funds, the lucrative nature of the private equity industry is obvious. A $2 billion fund charging a 2% management fee results in the firm earning $40 million every year, regardless of whether it is successful in generating a profit for investors. Particularly among larger funds, situations can arise where the management fee earnings exceed the performance-based earnings, raising concerns that managers are overly rewarded, despite mediocre investing results.
Just as the lucrative nature of the industry is obvious, it logically follows that LPs may be predisposed to search for better fee terms in the current economic climate. And, of course, the recent COVID-19 pandemic only accelerated that pace of challenges that fund managers already faced: ongoing fee compression, heightened compliance and regulatory changes (discussed in detail below) and limited organic asset growth. Indeed, in this market cycle, the relationship power appears to be shifting back to LPs, often resulting in fee discounts and/ or more LP-friendly terms.
VC Firms Face Challenges and Are Lowering Their Fees, Too
Venture investors saw a reshaped landscape over the past year. Both the startup fundraising market and VCs’ own ability to raise new funds were turned upside down after a banner 2021 in which easy money was the overarching theme, coupled with surging investments in crypto companies and the broader blockchain landscape.
In this realm, we’re also witnessing the paradigm change in favor of LPs. For example, Sequoia Capital lowered management fees in its two recently launched venture funds, as it braced for a slower investment environment. The changes in fee structure, outlined to investors in December, allow LPs who committed capital to Sequoia's crypto and ecosystem funds launched early last year to pay management fees based on capital deployed, rather than the common model of capital under management that applies to other Sequoia funds.
The move marks an unusual concession by one of the world’s top venture investors after U.S. venture capital deals fell from their 2021 peak by 31%. Sequoia's longstanding relations with LPs has been tested by crumbling valuations in tech companies and the fallout in its portfolio company FTX.
Drawing the Ire of Regulators
What’s more, in the U.S., all signs now indicate that private funds will continue to be under a greater regulatory microscope. When the Securities and Exchange Commission (SEC) announced its 2022 examination priorities last March, it explained that it intended to focus on funds’ “… fees and expenses, custody, fund audits, valuation, conflicts of interest, [and] disclosures of investment risks,” among other things. More recently, on February 7, 2023, the SEC’s Division of Examinations reaffirmed that the “calculation and allocation of fees and expenses, including the calculation of … management fees and the impact of valuation practices …” would remain a focus area.
In years past, private funds have had minimal regulatory oversight because their investors were mostly high-net-worth individuals who were better able to sustain losses in adverse situations and, therefore, they received less protection. Recently, however, some private funds have seen more of their investment capital coming from pension funds and endowments.
As leading law firm, Kirkland & Ellis, advised: “In this environment, private funds should make sure they have top-notch controls and … invest in their compliance programs.” In fact, we expect the SEC’s Division of Enforcement to continue to pursue more enforcement actions against the private fund industry throughout 2023. Another leading law firm, Akin Gump, has noted that private fund managers should consider the following lessons from recent enforcement actions:
Fund managers should continually monitor disclosures, especially regarding fees and expenses, ESG and conflicts of interest to make sure their disclosures are in step with actual practices.
The SEC also appears to have brought back the “broken windows” approach to enforcement actions involving non-scienter based rule violations such as the pay-to-play, custody and proxy voting rules, as well as Regulation M. Private fund managers should consider revisiting their policies and procedures in these areas and incorporating them into training modules and annual compliance reviews.
Related to the “broken windows” theme, the SEC appears to be actively investigating whether private fund managers have sufficient electronic communications procedures to satisfy their books and records obligations under the Advisers Act. Now is a good time to assess your electronic communications policies and emphasize the importance of compliance, including to senior personnel.
Insider trading continues to be a top enforcement priority where the SEC is willing to push the envelope, especially in cases involving “bad optics.” Private fund managers should continue to focus on insider trading training for investment personnel and ensure they have strong surveillance measures in place to mitigate this risk.
The SEC continues to bolster its oversight of the markets for cryptocurrency and other digital assets.
Technology to the Rescue
If 2023 hasn’t become ‘the year of the bottom line,’ then I don’t know what else it could be except, perhaps, ‘the year that smart firms doubled-down on technology’ to deliver a competitive edge. As both regulators and LPs tighten the figurative screws on private capital firms, leading fund managers have realized that harnessing the power of key emerging technologies is essential if they wish to thrive.
One of their biggest challenges on their horizon is the deluge of data that they face on two fronts: external investment and internal administration. On the external side, firms have to analyze increasing volumes of data to make better decisions about selecting potential portfolio companies. On the internal side, they must also contend with the growing need to provide an increasingly expansive array of data to investors, regulators and other stakeholders.
Despite mounting data pressures, some laggard firms continue to rely on manual processes and archaic spreadsheets to run the back office and their broader operations. But, when the cost of this approach is quantified, the resulting figures are eye-opening for fund managers and further summon the need to adopt purpose-built platform technology that can help them increase operational efficiencies, reduce costs and hasten time to revenue.
Now, candidly, gathering and analyzing private market data is not easy. But, in today’s market, having a platform that supports your data analytics strategy is no longer a “nice to have.” It’s absolutely required to drive business operations and digital transformation at your firm. For example, the use of Asset Class’ Private Capital Cloud data analysis functionality can yield a type of flywheel effect: the more data that is analyzed, the greater the opportunity to gain actionable insights and advantages in the investment lifecycle.
Imagine having one platform that not only helps you overcome your data challenges, but further digitizes the entire investment process—from onboarding investors to managing subscription documents, administering funds, delivering sound reporting, and beyond—in effect, the entire lifecycle of the investment experience. The outcomes: reduced resource overhead and related costs, streamlined (digitized) operations, and an integrated reporting and compliance framework that will keep investors happy and regulators off your back. So, if, indeed, your management fees do take a hit this year, the preceding outcomes can help alleviate some of the pain, as your firm is better positioned to capitalize on the eventual rebound of the economy.
Summary
Today, LPs are paying closer attention to both macroeconomic factors and the evolving management fee opportunities that are available to them—and your firm should, too. While it is unclear exactly when the economy will completely rebound, fund managers should be prepared for the fact that investors will push back on management fees with greater gusto in today’s market. Accordingly, private fund managers need to do some soul-searching and realize that the incredible management fees that they garnered a year ago may not be as handsome as what awaits them in the months to come.
Firms need to be true and convincing when it comes to their management fees and leverage the latest platform technology to give them a competitive edge. Those that do will be well-poised to harness the tailwinds that will accompany the rebounding economy in quarters to come.
Discover How Asset Class Can Help Your Team
Need help navigating the challenges that your firm’s management fees are facing and discovering the platform technology that’ll give your team an edge? This is exactly where our deep subject matter expertise lies. Today, the Asset Class Private Capital Cloud powers hundreds of VC & PE firms around the world. Discover how the platform can help make your financial firm - frictionless. Schedule a demo with one of our team members today.
Sources:
https://www.lexology.com/library/detail.aspx?g=6e30ea71-6a55-48fe-ac8d-e5b1478f4f34
Over the past decade, many private equity and venture capital firms have built incredible fortunes. A large amount of the money they’ve made has been through investments in companies that have outperformed expectations. However, a significant portion of gained wealth can be further attributed to management fees that quickly added up as fund sizes mushroomed to unprecedented levels.
Complex, onerous and opaque: these are several words that are often associated with such fees. For prospective investors, the management fees and carried interest charged by general partner fund managers can be a turnoff; but, historically, demand for private market opportunities meant that investors had little leverage over the fees. Now, though, given current marketing conditions, we’re witnessing the pendulum swing back in favor of limited partner investors.
Since the private market landscape has changed considerably over the past year, what happens now? Will the industry’s limited partners—the “money behind the money”—demand better terms from fund managers, just as venture capital (VC) and private equity (PE) firms are now making greater demands on startup founders and the companies that they invest in (or acquire)?
If ever there was a moment for the people that fund private market firms to use their leverage and push back, now would seem to be the time. So how can smart firms overcome the challenges that investors present to their fees? This article explores how the wisest among them are leveraging technology to deflate the pressure put on their management fees.
Setting the Stage: Private Market Funds and Concerns Around Management Fees
Private market funds are generally structured as limited partnerships. The manager of the fund is called the general partner (GP) and the investors that commit money to the fund are called limited partners (LPs). The GP invests the fund’s capital, manages the portfolio of investments, and executes exit events. LPs are passive investors who receive distributions from the fund.
In September 2022, Preqin published the results of its institutional investor survey, which focused on private fund fee terms and conditions. The survey results showed that transparency around fees, rather than the amount of fees charged, were of primary concern. Of the institutional investors surveyed, 59% indicated that transparency at the fund level required improvement, while 80% noted they have either frequently or occasionally decided not to invest in a private fund, due to the proposed terms and conditions. Therein lies the rub and the confluence of factors that have put firms’ management fees under greater pressure—investors’ lack of trust surrounding the fees, their enhanced leverage to seek better fee structures, and an economic climate that has led them to be increasingly selective when choosing which funds to invest in.
Private Equity Management Fees Under Pressure
Historically, private equity funds have a similar fee structure to that of hedge funds, typically consisting of a management fee and a performance fee, whereby most firms have a two-and-twenty fee structure. Under this paradigm, fund investors pay 2% per year of assets under management (AUM) plus 20% of returns generated above a certain threshold known as the hurdle rate.
When considering the management fee in relation to the size of some funds, the lucrative nature of the private equity industry is obvious. A $2 billion fund charging a 2% management fee results in the firm earning $40 million every year, regardless of whether it is successful in generating a profit for investors. Particularly among larger funds, situations can arise where the management fee earnings exceed the performance-based earnings, raising concerns that managers are overly rewarded, despite mediocre investing results.
Just as the lucrative nature of the industry is obvious, it logically follows that LPs may be predisposed to search for better fee terms in the current economic climate. And, of course, the recent COVID-19 pandemic only accelerated that pace of challenges that fund managers already faced: ongoing fee compression, heightened compliance and regulatory changes (discussed in detail below) and limited organic asset growth. Indeed, in this market cycle, the relationship power appears to be shifting back to LPs, often resulting in fee discounts and/ or more LP-friendly terms.
VC Firms Face Challenges and Are Lowering Their Fees, Too
Venture investors saw a reshaped landscape over the past year. Both the startup fundraising market and VCs’ own ability to raise new funds were turned upside down after a banner 2021 in which easy money was the overarching theme, coupled with surging investments in crypto companies and the broader blockchain landscape.
In this realm, we’re also witnessing the paradigm change in favor of LPs. For example, Sequoia Capital lowered management fees in its two recently launched venture funds, as it braced for a slower investment environment. The changes in fee structure, outlined to investors in December, allow LPs who committed capital to Sequoia's crypto and ecosystem funds launched early last year to pay management fees based on capital deployed, rather than the common model of capital under management that applies to other Sequoia funds.
The move marks an unusual concession by one of the world’s top venture investors after U.S. venture capital deals fell from their 2021 peak by 31%. Sequoia's longstanding relations with LPs has been tested by crumbling valuations in tech companies and the fallout in its portfolio company FTX.
Drawing the Ire of Regulators
What’s more, in the U.S., all signs now indicate that private funds will continue to be under a greater regulatory microscope. When the Securities and Exchange Commission (SEC) announced its 2022 examination priorities last March, it explained that it intended to focus on funds’ “… fees and expenses, custody, fund audits, valuation, conflicts of interest, [and] disclosures of investment risks,” among other things. More recently, on February 7, 2023, the SEC’s Division of Examinations reaffirmed that the “calculation and allocation of fees and expenses, including the calculation of … management fees and the impact of valuation practices …” would remain a focus area.
In years past, private funds have had minimal regulatory oversight because their investors were mostly high-net-worth individuals who were better able to sustain losses in adverse situations and, therefore, they received less protection. Recently, however, some private funds have seen more of their investment capital coming from pension funds and endowments.
As leading law firm, Kirkland & Ellis, advised: “In this environment, private funds should make sure they have top-notch controls and … invest in their compliance programs.” In fact, we expect the SEC’s Division of Enforcement to continue to pursue more enforcement actions against the private fund industry throughout 2023. Another leading law firm, Akin Gump, has noted that private fund managers should consider the following lessons from recent enforcement actions:
Fund managers should continually monitor disclosures, especially regarding fees and expenses, ESG and conflicts of interest to make sure their disclosures are in step with actual practices.
The SEC also appears to have brought back the “broken windows” approach to enforcement actions involving non-scienter based rule violations such as the pay-to-play, custody and proxy voting rules, as well as Regulation M. Private fund managers should consider revisiting their policies and procedures in these areas and incorporating them into training modules and annual compliance reviews.
Related to the “broken windows” theme, the SEC appears to be actively investigating whether private fund managers have sufficient electronic communications procedures to satisfy their books and records obligations under the Advisers Act. Now is a good time to assess your electronic communications policies and emphasize the importance of compliance, including to senior personnel.
Insider trading continues to be a top enforcement priority where the SEC is willing to push the envelope, especially in cases involving “bad optics.” Private fund managers should continue to focus on insider trading training for investment personnel and ensure they have strong surveillance measures in place to mitigate this risk.
The SEC continues to bolster its oversight of the markets for cryptocurrency and other digital assets.
Technology to the Rescue
If 2023 hasn’t become ‘the year of the bottom line,’ then I don’t know what else it could be except, perhaps, ‘the year that smart firms doubled-down on technology’ to deliver a competitive edge. As both regulators and LPs tighten the figurative screws on private capital firms, leading fund managers have realized that harnessing the power of key emerging technologies is essential if they wish to thrive.
One of their biggest challenges on their horizon is the deluge of data that they face on two fronts: external investment and internal administration. On the external side, firms have to analyze increasing volumes of data to make better decisions about selecting potential portfolio companies. On the internal side, they must also contend with the growing need to provide an increasingly expansive array of data to investors, regulators and other stakeholders.
Despite mounting data pressures, some laggard firms continue to rely on manual processes and archaic spreadsheets to run the back office and their broader operations. But, when the cost of this approach is quantified, the resulting figures are eye-opening for fund managers and further summon the need to adopt purpose-built platform technology that can help them increase operational efficiencies, reduce costs and hasten time to revenue.
Now, candidly, gathering and analyzing private market data is not easy. But, in today’s market, having a platform that supports your data analytics strategy is no longer a “nice to have.” It’s absolutely required to drive business operations and digital transformation at your firm. For example, the use of Asset Class’ Private Capital Cloud data analysis functionality can yield a type of flywheel effect: the more data that is analyzed, the greater the opportunity to gain actionable insights and advantages in the investment lifecycle.
Imagine having one platform that not only helps you overcome your data challenges, but further digitizes the entire investment process—from onboarding investors to managing subscription documents, administering funds, delivering sound reporting, and beyond—in effect, the entire lifecycle of the investment experience. The outcomes: reduced resource overhead and related costs, streamlined (digitized) operations, and an integrated reporting and compliance framework that will keep investors happy and regulators off your back. So, if, indeed, your management fees do take a hit this year, the preceding outcomes can help alleviate some of the pain, as your firm is better positioned to capitalize on the eventual rebound of the economy.
Summary
Today, LPs are paying closer attention to both macroeconomic factors and the evolving management fee opportunities that are available to them—and your firm should, too. While it is unclear exactly when the economy will completely rebound, fund managers should be prepared for the fact that investors will push back on management fees with greater gusto in today’s market. Accordingly, private fund managers need to do some soul-searching and realize that the incredible management fees that they garnered a year ago may not be as handsome as what awaits them in the months to come.
Firms need to be true and convincing when it comes to their management fees and leverage the latest platform technology to give them a competitive edge. Those that do will be well-poised to harness the tailwinds that will accompany the rebounding economy in quarters to come.
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Sources:
https://www.lexology.com/library/detail.aspx?g=6e30ea71-6a55-48fe-ac8d-e5b1478f4f34
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