When it comes to fund management fees, the focus for managers and investors is often on the headline fee rate. However, the manner in which the management fee base is determined can also have a material impact on the fees ultimately charged. This article compares the most common models for private credit funds and explores different approaches to charging management fees on the fund’s borrowings.
Management Fee Base Models
Broadly speaking, there are three management fee base models adopted by private credit fund managers, although there are many available variations to these, and more bespoke arrangements may also be entered into with individual LPs.
1. Invested Capital
This is increasingly the most common approach for private credit funds. Under this method, management fees are charged on invested capital throughout the fund’s term. Invested capital is calculated by reference to initial investment cost (as opposed to NAV), and it is usually reduced as investments are realized / principal is returned.
Typically, there will be no fee on unfunded commitments, although if a fee is charged on unfunded commitments, this will typically only be applied during the investment period and may be at a lower rate compared to invested capital to incentivize quicker deployment.
There are several approaches to defining the scope of “invested capital”, including the treatment of borrowings (see below), costs and expenses and committed but not deployed amounts. The different approaches can become quite nuanced, and getting the invested capital definition correct is key to ensuring that this captures all components of the intended management fee base.
2. Committed Capital during the Investment Period and Invested Capital after the Investment Period
Although not as common as for private equity and venture capital funds, many private credit funds continue to adopt the model of taking fees on committed capital during the investment period and on invested capital post-investment period. This model can be more common for credit strategies that lend themselves to slower rates of deployment.
Like most private equity funds, private credit funds using this model are less likely to include borrowings in the management fee base. The post-investment period management fee may also be subject to a lower fee rate for credit strategies where there is less active management required post-investment period.
3. NAV
Particularly for managers who also focus on (or historically were focused on) public assets, using the net asset value (NAV) for the management fee base is also common. Using NAV places increased importance on valuations (and therefore will not be suitable for certain hard-to-value strategies) and subjects the manager to any volatility with the NAV (the risk of this will be strategy dependent). For evergreen private credit funds, NAV is often used.
Borrowings
1. Subscription Line Credit Facilities
The use of subscription line credit facilities (‘sub-lines’) has become a common feature for private credit funds, although their use raises interesting questions as to whether amounts drawn down under a sub-line should form part of the management fee base. For funds adopting the invested capital model, this provides the manager with quicker access to management fees. Including sub-line drawdowns can be justified as this capital is being managed, and therefore the manager should be compensated for doing so, but investors will often negotiate for the preferred return to accrue on these amounts.
2. Investment Leverage
For private credit funds deploying leverage for investment purposes, there is a split in approach among managers as to whether management fees are charged on leverage, although we have seen a number of private credit fund managers including leverage as part of the management fee base. In particular, where a private credit fund manager offers levered and unlevered parallel funds for the same strategy, it is common for management fees to be charged on leverage for the levered parallel fund. Where there is a high borrowing cap on the leverage that can be utilized by a fund, investors may look to negotiate a cap on the amount of leverage that counts towards the management fee base.
