10.1.

9: Fees and Expenses

Another controversial issue, where again careless drafting is often encountered, has to do with the
allocation of expenses. The notion of a standard norm is prevalent-that is, that industry standards
contemplate a management fee of between 2% and 3% of the assets of the investor partnership, perhaps
subject to break points in a large partnership-for example, 3% of the first $10 million, 2% of the next
$20 million, and so forth. The provision appears to be uncomplicated but matters are not that simple.
Thus, a commonly encountered confusion arises in computing the measuring base for the fee calculation;
the choices include a given percentage (say, 2.5%) of: (1) the actual cash contributed by the investors;
or, (2) the amount they have committed to contribute (a much larger figure than actual cash in the early
going, since investor contributions are usually made in installments); or, (3) the aggregate capital
accounts of the partnership (a figure subject to diminution as losses are incurred or distributions in excess
of profits are made); or, (4) the appraised value of the assets of the investor partnership. If there is one
most frequent pick, it is to select committed capital, the aggregate amount the investors have agreed to
put in. The problem with actual cash (versus committed cash) is that, if contributions are made in
nstallments, the measuring base of the management fee is quite small in the early years and yet the
expenses remain constant. Measuring the management fee against the appraised value of the assets of the
investor partnership might make abstract sense in that it rewards the managers if the assets go up and
penalizes them if shrinkage occurs, but it puts a good deal of pressure on the subjective process of
appraising assets. Moreover, such a system may artificially spur the managers to invest assets
prematurely.
[1]
One further note in this connection: the more recent fashion has been to ramp fees up in
the early years (when the fee, if measured by committed capital, could be a startling percentage of
contributed capital) and then tail the fee down in the later years, when the process of harvesting
investments is viewed as less onerous than selecting and managing the same.
[2]

A somewhat subtler issue has to do with the relationship between the management fee and the expense
allowance. It was at one time generally understood that the purpose of a management fee was not to
provide a profit to the GPGP but to compensate it for the ordinary and necessary expenses of running the
partnership; that understanding may be changing as the size of some of the recently organized
partnerships inflates, but there remains the central underlying notion that the management fee is in the
nature, primarily, of a reimbursement. Indeed, the size of many recently organized partnerships has been
driven by the necessity for a denominator large enough to throw off fees adequate to pay bills. Since the
cost of two professional managers, secretarial service, rent, reports to investors, and unallocated travel is
in the neighborhood of $500,000 annually in todays market, the minimum size of a typical pool, at a 2.5%
annual fee, is not much less than $20 million.
The often-overlooked question is: Which expenses are included within the management fee and which are
chargeable to the investor partnership? Obviously, a $500,000 annual allotment will not cover a number of
the investor partnerships expenses, assuming the managers are to take any salaries at all. Legal fees for
making investments, for example, can amount to $20,000 - $25,000 per investment. If the investment is
successfully closed, that amount can be capitalized and added to the cost basis of the investment but the
Page 1 of 3 10.1.9: Fees and Expenses - Encyclopedia - Library - VC Experts
fees incurred in structuring deals that turn out to be dry holes have to be charged to someone. So also
with the legal and accounting costs of maintaining the investor partnership, preparation of tax returns,
brokerage commissions, litigation costs, expenses of investor relations (limited partners meetings are
often held in exotic venues), and travel expenses associated with successful and/or unsuccessful portfolio
investments. In each case there are three sources for the payment: (1) capitalize the expense and charge
it to the basis of the investment (another way of saying that the investor partnership pays in the end); (2)
charge it to the investor partnership as an annual expense; or, (3) lay off the expense on the GPGP,
against the management fee.
The current custom is to construe the expenses included within the management fee-that is, the GPGPs
problem-quite sparingly. Typically, the management fee covers only salaries of the full-time professionals
and administrative personnel and the ordinary and necessary G&A expenses involved in routine operations
of the investor partnership. Legal and accounting fees, and, in fact, all the other costs mentioned, are
charged to the investor partnership as a current or capital expense. Consulting fees, for example, can be a
major burden; many managers routinely elect to obtain a consultants report when considering an
investment. Typically, consulting fees are added to basis or charged to the investor partnership-the GPGP
usually cannot afford to pay them. (A well-drafted agreement will contain restrictions on the payment of
consulting fees to affiliates of the GPGP so that the consulting fee is not a disguised addition to the GPGPs
compensation. Similarly, when and if managers serve on the boards of portfolio companies and are paid
directors fees, it is the usual rule that such fees are either remitted to the investor partnership or credited
against the management fee, to avoid double counting.)
[3]

If a placement agent is retained, its fee could be paid by the GPGP (on the theory that it is the promoters
responsibility to raise the money); however, such is not the practice.
[4]
Placement fees are generally paid
by the investor partnership, in which case there is a choice: Either the capital accounts of all the partners
will be debited, or the fees will be charged to the capital accounts of only those partners who are
introduced by the placement agent.
It is customary for the managers to form a service corporation and assign the management fees to it in
consideration of its providing the general and administrative services for which the GPGP is responsible.
This entities the employees of the corporation to certain fringe benefits (group life and health insurance),
which remain more favorable on an after-tax basis than if they were partners in, or employees of, the
partnership.
[1]
Some agreements provide for a Consumer Price Index inflator, annually amending the management fee
upward.
[2]
1993 Term's at 23. One result of skinny, just-in-time installments is that there is often no cash on hand
with which to pay the management fee in the early years unless a call is sent out for that specific purpose.
Based on a highly visible, albeit unreported, case in Iowa in which the author participated, the partnership
agreement should make it clear that calls can be made in order to raise cash to pay fees.
[3]
See I Halloran at 1-96. Netting income derived from the fact that services have been provided against
management fees also serves to keep such income away from the partnership and thus avoid the specter
of unrelated business taxable income. See 14.19.
[4]
If the GPGP is not responsible for raising the funds-i.e., the partnership is sponsored by a limited
Page 2 of 3 10.1.9: Fees and Expenses - Encyclopedia - Library - VC Experts
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partner or its affiliate-the usual adjustment is to reduce the carry from 20% to some lesser number -
say, 15% or 10% - and/or for the sponsoring investor to share in the carry to that extent. Further,
organizational expenses of the investor partnership-principally legal and accounting fees-are often subject
to a cap, with the GPGP (or, more probably, the lawyers and accountants) shouldering the excess.
Page 3 of 3 10.1.9: Fees and Expenses - Encyclopedia - Library - VC Experts