Three words are commonly associated with fees related to private funds: onerous, opaque, and complicated. For some prospective investors, the management fees and carried interest charged by the general partnerships that manage these funds can be a turnoff.

So too can the investment time frame; assets can be tied up for seven years or more. For many qualified investors, however, private funds can be worth the trouble.
 
Private funds can include any illiquid limited partnership structure, such as private equity, real estate, and/or credit. They typically have an investment period of between two to six years, during which time the fund makes investments and draws down capital. This is followed by a harvesting period of two to six years, when the fund liquidates its investments and returns the proceeds to the limited partners.
 
So, what’s the attraction? Investors who can tolerate the illiquidity and the relatively high fees can be rewarded with relatively high net returns. The private equity market over the past three decades outperformed the S&P 500 Index net of fees by at least 300 basis points annually over 10-, 15-, 20-, and 25-year periods, as illustrated by the chart on page 11. For top quartile funds, the premium was even higher, around 500 basis points annually. In addition, many private fund returns, particularly from private equity and real estate, are relatively tax-efficient, as most are treated as long-term capital gains. In the current low-return environment, there is a compelling case for owning tax-efficient assets with a demonstrated return premium.
 
Let’s focus on the different components of private funds, highlighting what we believe are the industry’s best practices. The interests of the general partners, or the fund management company, should align to the interests of the limited partners, or the investors.

Management Fees

Typically, general partners charge management fees that range from 1.25% to 2.00% to their limited partners for primary funds. Management fees are generally charged on committed capital. In other words, after the investor makes a commitment to a fund, management fees are charged on the entire commitment amount, regardless of whether the capital is actually drawn or invested. Some funds charge only on invested capital, which lowers the management fees charged to the limited partners, but may incentivize the managers to chase potentially bad deals for the sake of investing capital.
 
There are two other ways that the general partners can generate money from fund fees, neither of which is well disclosed. Almost all private funds charge an additional administrative fee that transfers selected fund expenses and shared services (including fixed costs such as audit, accounting, and legal) to the limited partners. In contrast to mutual funds (in which these fees are transparent and capped), they tend to be buried in the fund’s private placement memorandums or even undisclosed.
 
Best practices here are for capped administrative fees in either a hard dollar amount or in basis points of assets under management. They should amount to no more than 0.10% to 0.15% of fund assets.
 
In addition, private funds often receive other fees from third parties related to the activities of the fund. These can include placement fees, directors’ fees, and transaction fees. Ideally, these additional fees are credited 100% back to the limited partners, reducing the net management fee paid.
 
It’s generally preferable to invest in funds that charge on invested capital, instead of on committed capital. Investors are right to be wary of funds with multiple entries in their administrative fund expense columns. Certainly, firms that keep all or most of the fees they generate from third parties for the general partners should raise a red flag.

Carried Interest

All these management and administrative fees often don’t cover much more than the general partners’ operating expenses. The real moneymaker for the owners of the most successful private funds is carried interest, also known as the incentive fee. Carried interest is also how general partners align their interest with the limited partners, as they only make significant money on their funds if their investors do well.
 
Typically, general partners take between 15% and 20% of the fund’s net profit (after management fee), but in some cases the incentive fee can be as high as 30%. Carried interest taxation has been under extreme criticism from all political fronts, as the money made by general partners on carried interest is currently treated as a long-term capital gain.
 

 
In almost all cases, the general partners can’t charge any incentive fees until the fund achieves a certain preferred return, or hurdle rate. These rates typically range from 5% to 8% of the fund’s net profit and are compounded annually. A higher preferred return means a better alignment of incentives, which is friendlier to the limited partners. In other words, preferred returns ensure that the limited partners don’t start paying incentive fees until they have received a reasonable return for the risk they are taking.

Do the General Partners Invest in Their Own Fund?

One of the best ways a general partner and, ideally, all the other investment professionals at the fund, can demonstrate proper alignment of incentives is to invest significant amounts of their own assets into their funds alongside their limited partners (1% to 5% of the total fund’s assets is typical; a minimum of 2% is preferable). There is no better way to demonstrate confidence in one’s abilities than to eat one’s own cooking.

Worth the Trouble

It’s important to approach investing in private funds with a selection framework, to properly analyze and evaluate the associated fees. Yes, the fees are complicated. But there is real value in the sector, and careful investment can reward patient investors. A portfolio of private funds with reasonable fee structures and, as we will discuss in future issues of Independent Thinking, different vintage years (inception dates) and manager diversification can enhance a portfolio’s overall risk-adjusted return without dramatically increasing risk.
 
Brian Pollak is a Partner and Portfolio Manager at Evercore Wealth Management. He can be contacted at brian.pollak@evercore.com
 
Editor’s note: This is the third installment in a series on investing in illiquid assets. To read the earlier issues, please visit our archives.