Compensation / Fees

Strictly, an advisory fee is paid for advice from a consultant or manager, while a management fee or GP's share is paid for taking on responsibility to act on behalf of another - typically a fund entity that may have no legal personality of its own and acts through a General Partner (e.g. Jersey or Guernsey limited partnerships).

The distinction between adviser and manager is not always clear; an "adviser" may hold enough authority that "manager" would be more accurate. The fee structure typically changes over time and results from negotiation during fund-raising - the better the track record, the stronger the GP's position - usually with a mechanism that reduces the fee over time or in line with portfolio value.

Fees the GP collects from third parties in the course of the fund's business (transaction, finder, co-investment and underwriting fees) are typically deducted from the GP's share. In Norway, managing a fund is VAT-exempt while giving financial advice is not - important, as most investment companies are not VAT-registered and cannot recover VAT.

The extraordinary share of profit due to the GP when the fund's performance exceeds a certain annual return, often the hurdle rate. Carry is typically 10-30% of the return above the hurdle and is disproportionate to the amount the GP has itself invested.

Carry is commonly calculated on total fund performance - the most LP-friendly scheme - and is not paid until paid-in capital and the hurdle element have been distributed to investors. The most GP-friendly scheme is strict "deal by deal" carry, where the GP earns carry on one successful exit even if the rest of the portfolio would, if realised, show losses. Many intermediate solutions balance GP motivation and LP return.

Best shown by example. A fund invests 100; a year later 110 is realised, with an 8% hurdle and 20% carry.

Without catch-up the LP receives the 100 invested + 8 hurdle + 80% of the remaining 2 = 109.6, and the GP receives 0.4. With full catch-up the LP receives 100 + 8, and the remaining 2 goes entirely to the GP, so the whole 10 return is split 80/20 - the GP has "caught up" with the LP after the hurdle is paid.

The LPA's clawback terms set out how and when the fund may recover money already paid to the GP - typically because an event has reduced the fund's performance below the basis on which carried interest or fees were paid.

Points to watch: tax the GP has already paid is normally not subject to clawback; how clawback works after in-kind distributions; and how it works following ownership changes in the fund.

The minimum annual return on net capital paid into the fund that is due to the investor before the GP can earn carried interest. If performance falls below the hurdle, there is no carry.

The market standard is 8%, though rates of 5-12% occur. In theory it should be lower when interest rates are low and vice versa; in practice it has been remarkably stable, which matters given a typical 10-15 year fund life over which rates fluctuate.

A fee charged at subscription, payable at first close, typically calculated on committed capital and used to cover the fund's establishment costs. Its size tends to depend on the expected fund size, as set-up costs are not necessarily linear with committed capital.

Fees directly referable to making an investment. The LPA typically provides that any transaction fees the investment adviser or GP receives from a third party in connection with a fund transaction are deducted from the advisory fee for the period.

The distribution mechanism. The waterfall clause in the LPA sets out who receives the first money distributed, and so on, until all the fund's assets are distributed and the fund closed.

A typical waterfall: after costs, the LPs and the GP-as-investor are first in line up to the amount paid in; next, funds permitting, they receive the hurdle return; if there is a catch-up it follows; finally, remaining assets are split between the LPs and the GP as recipient of carried interest. Timing clauses can complicate matters - the GP wants carry as early as possible, and LPs may accept this subject to escrow and clawback conditions requiring repayment if later events hurt performance.