BFP #OpenLP Series (7) — Premium Carry

What do we see in terms of GP’s charging Premium Carry?

The fee structure of a fund is one of the last things we look at when we evaluate a fund. However, if there are two competing managers that we really like, the fee structure can tip the scale in the investment decision.

To get a view of market practice we have analyzed the fee structure of the last 100 VC fund investment opportunities – across the US, Europe and Asia-Pacific – which we have reviewed. As per our strategy, these are all managers with fund sizes below US$ 200 million and focused predominantly on Seed and Series A investing.

Our key findings have been the following:

  • Out of the 100 funds sampled, 11% (11 funds) charged a Premium Carry, which we define as a performance fee in excess of the standard 20%
  • Out of these 11 funds, in 2/3rd of the cases the performance fee ratcheted up to 25%; in 1/3rd of the cases it ratcheted up to 30%
  • In most cases, the Premium Carry kicks in after a performance hurdle, which is most commonly above a 3x return of capital (38% of cases)
  • 2 funds charged a flat 25% carry with an absolute hurdle of 20% (thus avoiding the annual hurdle rate common in Europe, which creates a misalignment of interest in our opinion)
  • 73% of the funds charging premium carry did not have a catch-up clause on the premium carry (i.e. the additional performance fee is only charged on the incremental dollars over and above the return hurdle).

What about Management Fees?

Arguably there is a trade-off between Management Fees and Carry. Some LPs are willing to pay a higher Carry if compensated by lower Management Fees:

  • Out of the sample of 100 funds, over 80% have a stepdown in Management Fees throughout the life on the fund
  • Whilst the average fee charged by all funds in the sample was 2% p.a., there was a higher variance around that mean amongst those funds charging Premium Carry:
    Out of the 11 funds with a Premium Carry, 36% charge fees higher than 2% (compared to 19% when considering the whole sample), and 36% charge fees lower than 2% (compared to 25% when considering the whole sample).

There are two ways to think around Management Fees for Emerging Mangers with small funds: 1) GP’s need the management fees to invest in the infrastructure that enables them to do their job well, and 2) high Management Fees reduce the investible capital of a fund and therefore reduce the net return potential of a fund.

Of course, the impact of Management Fees on fund performance can be reduced by active recycling (often up to around 115%). However, this can be tricky to implement in practice as it relies on early liquidity which is hard to predict. Also, a recycling policy reduces early liquidity paid out to the LP.

…so what’s our take?

Few LPs will pass on a top performing manager just on the basis of fees. However, in the nowadays highly competitive environment of Emerging Managers, where LP’s are often taking a bet on less established set-ups, the fee structure can influence the investment decision when it’s a close call between two equally strong managers.

There is a lot of talent out there, and our advice for Emerging Managers would be not to push the envelope straight off the bat. There are some less mature markets where some outstanding managers can get away with premium fees, but both the US and Europe in our view are too competitive for managers to push the envelope on this front.

The exception is where there is a real trade-off between significantly lower Management Fees in favor of a higher carry, e.g. 1.5%/25%. However, plain vanilla fee structures simplify the equation in the investment decision of many LPs.

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