By Anne Anquillare, Chief Executive Officer and President of PEF Services LLC
When GPs find themselves in a defensive position, they can’t make the best decisions for the fund and their investors. And fee and expense allocation has become one of the areas where GPs often feel as though they are on the back foot. How can GPs help LPs understand and support allocation decisions so that they can regain investor trust?
These three best practices that can help to clear the air and reinforce the alignment between the best interests of both sides.
1. Transparent Reporting
“Transparency” is often mentioned in the discussion around fees and expenses. The standardization that ILPA brings to the table can provide greater transparency and eliminate or cut down on the investor-specific requests that are supplemental to the fund’s reporting process. While it may seem painful to adopt, it’s ultimately better than having many different investor request templates to fill out.
According to a survey, we conducted in partnership with PEI, Pepper Hamilton, and Withum, only 17% of GPs are using the ILPA fee-reporting template. However, a further 38% are using a modified version. Note that this guidance is relatively new. More sophisticated LPs are starting to push for the use of the templates; therefore, we expect this to shift in the near term.
Some of the clear benefits we see in the ILPA templates are in the area of management fees. While management fees may appear to be a simple calculation when reviewing a Limited Partnership Agreement, they typically can’t be recalculated without knowing the impact of offsets, waivers, and rebates, which are included in the template.
The incentive allocation, which is often buried in unrealized gains and distributions for the purpose of investor reporting and disclosed in the financial statements at the fund level, is arguably the most difficult amount to verify and track. The new fee template provides a clear roll forward of accrued incentive allocation at the beginning of the period with detailed adjustments for incentive allocation paid during the period and the change in accrued incentive allocation for the period to arrive at the ending balance.
2. Allocation Framework
Governing documents and industry templates can help you bring clarity to the allocation of fees and expenses, but they won’t cover all of the fees and expenses you encounter. For this part of the process, you need to develop a framework to guide the myriad of allocation decisions that are made about fund and management expenses.
This framework also can demonstrate your firm’s approach to fiduciary duty, since under the Investment Advisors Act of 1940, registered investment advisors (RIAs) have a fiduciary duty to act in the investors’ best interests. Even if you are not an RIA today, investors would like you to run the firm with that same fiduciary approach.
Because the private equity industry evolves rapidly and the investment periods can stretch into a decade or more, GPs are faced with the need to make decisions about fees and expenses that didn’t even exist when they first developed the agreements and policy documents to govern allocations.
For example, no one was thinking about cybersecurity eight years ago, whereas today it’s part of the cost of doing business. While we can’t anticipate the future, we can create decision frameworks that help us make consistent, rational, defensible allocations. Ultimately, it comes down to identifying the primary beneficiary.
By getting the LPAC’s buy-in on the policies and any new interpretation of those policies, GPs can preempt the second-guessing and scrutiny.
3. Proactive Communication
Even GPs who are making strides in reporting transparently and developing an allocation framework may be missing one final ingredient in developing a collaborative approach to fees and expenses. That ingredient is communication.
Many GPs don’t recognize the importance of communicating a compelling rationale for the expenses allocated to the fund. But if they communicate the positive impact these expenditures will have on the long-term value of the fund, LPs will appreciate the communication and will then have the information they need to monitor their investment and gauge the positive result. Nobody likes to hand over money without receiving some kind of benefit in return, and for fund expenses, the return may not manifest for years. But when the impact is communicated up front, it can allay concerns and strengthen LP confidence.
As an example, if you’re bringing on an “operating partner”, make sure the LP knows who they are, what kind of track record they have in the industry, how much they’re being paid by both the portfolio company and the fund, what plan of action the executive will set in motion, and what kind of an impact this will have on the investment. This type of proactive communication can be invaluable in keeping LPs on board and in sync with your strategy.
Fees and expenses have become a perennial source of confusion and mistrust between GPs and LPs, but they don’t need to be. By adopting ILPA reporting standards (or a similar version that address your investors’ needs), developing an expense allocation policy that is reviewed and approved by the LPAC annually, and communicating a clear rationale for the fees and expenses incurred, GPs can regain investor trust in an increasingly competitive and scrutinized asset class.
For practical solutions to addressing Fees and Expense alignment, read this white paper.