Private fund managers have traditionally borne their own costs and expenses when providing services to their funds, be it in relation to portfolio management, investment advice or other support functions they may undertake (e.g., legal, compliance, accounting and/or operational functions). However, over the past few years, there has been a notable shift in the market, particularly in Europe, with some or all of such costs and expenses increasingly being recharged to funds.
Context
In the past, it was commonly accepted that managers, who are typically remunerated through management fees and performance compensation such as carried interest, should not burden funds with additional costs and expenses that could erode returns. By absorbing their own internal expenses, managers demonstrated their commitment to maximizing their funds’ performance and ensuring that the majority of the capital contributed by investors was directed towards investments rather than operational overheads.
Market Evolution
In recent years, the landscape has evolved. Several (non-exhaustive) factors have contributed to the growing prevalence of recharging managers’ expenses to private funds:
Increased Complexity and Regulation
The private funds industry has become more complex, with heightened regulatory scrutiny and compliance requirements. Legislative bodies across the globe have implemented new rules and guidelines aimed at increasing transparency, protecting investors and ensuring market stability (e.g., AML and ESG rules). At the same time, many investors have also found themselves subject to increased regulatory and/or reporting requirements leading them to impose additional demands upon the funds in which they invest. Such regulations and increased investor demands often require managers to implement more robust compliance frameworks, which include detailed reporting, regular audits and comprehensive risk management systems.
This triggers the need for specialized personnel, investment in advanced compliance software and the establishment of internal controls to monitor and report on various aspects of funds’ operations. Given these increased operational demands, managers often now argue that the associated costs should be shared with the funds (or the relevant investors therein) to reflect the true cost of managing investments.
Manager Sophistication
Managers have grown in size and often now have the ability to perform certain services in-house that would have previously been outsourced (e.g., legal and compliance functions). By bringing certain functions in-house, managers can potentially achieve significant cost savings compared to outsourcing such functions to external service providers who often charge premium rates for their expertise.
Expenses associated with such services would typically fall within the definition of “fund expenses” if provided by a third party and, accordingly, managers often argue that the funds should bear the cost of such services even if performed in-house. On the whole, this is beneficial for investors since in-house services can be cheaper than outsourcing, which can lead to higher net returns for investors.
Investor Sophistication
Investors have become more sophisticated and expect greater transparency around costs and expenses. At the same time, managers are willing to be more transparent about the costs associated with fund management and openly disclose their operational costs in the fund documents.
This increased transparency benefits both parties. For investors, it provides a clearer understanding of the true cost of the funds in which they invest, enabling them to make more informed investment decisions. For managers, this transparency helps build trust and credibility with their investors, fostering a more collaborative and trusting relationship, which is crucial for the long-term success of the funds.
Therefore, while investors are paying closer attention to expenses provisions and more inclined to negotiate such provisions, they are generally willing to agree to the recharging of certain expenses by the manager as long as the manager is transparent and able to justify the costs involved.
Alignment of Interests
While the costs associated with managers’ internal functions are more frequently recharged to funds, managers often still bear a portion of these (e.g., via an annual cap on the amount of certain expenses that can be recharged). As a result, they are incentivized to manage these expenses prudently. High costs would also directly impact the funds’ performance, reducing the returns available to investors and diminishing the managers’ carried interest.
This cost-sharing mechanism ensures that managers remain accountable for their spending decisions and must justify the value and necessity of the costs being recharged to the funds. This accountability necessitates a culture of financial discipline and encourages managers to continuously evaluate and optimize their operational processes.
Conclusion
The trend of recharging managers’ costs and expenses to private funds reflects broader changes in the industry, driven by regulatory demands and investor expectations. As this practice continues to evolve, it will be crucial for managers and investors to navigate these changes thoughtfully to ensure sustainable and mutually beneficial outcomes in a rapidly changing market.
