Subtract the firm's budget from the percentage fee year by year, give back the carry, and check the fund size before agreeing to it.
A budget-based management fee replaces the percentage with the firm's approved operating budget, so the LP saving is simply the conventional fee less the budget, year by year. On an illustrative $600m buyout fund, 2 per cent in the investment period and 1.5 per cent on net invested capital afterwards totals $81.6m; a $9.0m budget growing 3 per cent a year, then a wind-down budget, totals $67.78m. LPs save $13.82m, 2.3 per cent of commitments, keep 80 per cent of it after carry, and the net TVPI rises from 1.576x to 1.609x. Below a fund size of about $450m the same budget would cost more than 2 per cent.
Worked in full in Private Equity Investor Relations by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Large LPs and anchor investors ask for budget-based fees because a percentage fee on a large fund produces a profit before any investment has been made. The ILPA Principles have long said that management fees should be based on reasonable operating expenses and reasonable salaries. For the investor relations team, the request raises two questions: what the proposal is worth to the LP, and what it costs the firm. Both are arithmetic, and the answers depend heavily on fund size.
| Input | Value |
|---|---|
| Commitments | 600 |
| Conventional fee, years 1 to 5 | 2.0% of commitments |
| Conventional fee, years 6 to 10 | 1.5% of net invested capital |
| Net invested capital, years 6 to 10 | 480, 400, 300, 180, 80 |
| Operating budget, year 1, growing 3% a year | 9.0 |
| Wind-down budget, years 6 to 10 | 6.0, 5.0, 4.0, 3.0, 2.0 |
| Capital invested / gross multiple / carry | 500 / 2.0x / 20% |
Years 1 to 5: 600 × 2.0% = 12.0 a year, 60.0 in total
Years 6 to 10: 1.5% × (480 + 400 + 300 + 180 + 80) = 21.6
Total = 81.6, 13.6% of commitments
Years 1 to 5: 9.0 × (1 + 1.03 + 1.03² + 1.03³ + 1.03⁴) = 47.78
Years 6 to 10: 6.0 + 5.0 + 4.0 + 3.0 + 2.0 = 20.0
Total = 67.78, 11.3% of commitments
Saving = 81.6 − 67.78 = 13.82, or 2.3% of commitments
LP share of the saving = saving × (1 − carry rate) = 13.82 × 80% = 11.05
In Excel: =SUM(ConvFee)-SUM(BudgetFee), then =Saving*(1-Carry) when the fund is above its hurdle.
| Year | Conventional | Budget-based | LP saving |
|---|---|---|---|
| 1 | 12.00 | 9.00 | 3.00 |
| 2 | 12.00 | 9.27 | 2.73 |
| 3 | 12.00 | 9.55 | 2.45 |
| 4 | 12.00 | 9.83 | 2.17 |
| 5 | 12.00 | 10.13 | 1.87 |
| 6 | 7.20 | 6.00 | 1.20 |
| 7 | 6.00 | 5.00 | 1.00 |
| 8 | 4.50 | 4.00 | 0.50 |
| 9 | 2.70 | 3.00 | −0.30 |
| 10 | 1.20 | 2.00 | −0.80 |
| Total | 81.6 | 67.78 | 13.82 |
Almost all of the saving comes in the investment period, when 2 per cent of a $600m fund pays a $9.0m cost base with a 25 per cent margin. After the step-down the two fees converge, and in years 9 and 10 the budget is 1.1 higher in total, because a firm still has to audit, report on and sell the last assets when net invested capital is small. A budget-based proposal that caps the tail as well as the early years is worth more to the LP than one that only trims the start.
| Item | Conventional | Budget-based |
|---|---|---|
| Paid-in capital (invested plus fees) | 581.60 | 567.78 |
| Gross proceeds at 2.0x | 1,000 | 1,000 |
| Carried interest at 20% of profit | 83.68 | 86.44 |
| Distributions to LPs | 916.32 | 913.56 |
| LP profit | 334.72 | 345.77 |
| Net TVPI | 1.576x | 1.609x |
Distributions fall slightly because carry rises by 2.76: lower fees mean more profit, and the GP takes a fifth of it. But the LPs pay in 13.82 less, so their profit rises by 11.05 and the net TVPI by 0.033. For the firm the trade is the mirror image: it gives up 13.82 of fee and gets 2.76 back as carry, a net cost of 11.05 that it can only recover by performing.
A budget does not scale with commitments; a percentage does. The comparison below covers the five-year investment period only, with each budget growing 3 per cent a year.
| Fund size | Year-1 budget | Budget, % of commitments | 2% fee, 5 years | Budget, 5 years | LP saving |
|---|---|---|---|---|---|
| 300 | 6.5 | 2.17% | 30.0 | 34.51 | −4.51 |
| 600 | 9.0 | 1.50% | 60.0 | 47.78 | 12.22 |
| 1,200 | 13.0 | 1.08% | 120.0 | 69.02 | 50.98 |
On a $300m fund the honest budget is above 2 per cent, and a budget-based fee would raise the LPs' cost by 4.51. On a $1,200m fund it saves 50.98 in five years. A $9.0m budget equals 2 per cent of a $450m fund; above that size the percentage fee is profit, below it the firm is subsidising the fund from its own pocket or from an earlier fund's fees. This is why budget-based terms are a large-fund, large-LP negotiation, and why the request often comes with a successor fund that has grown, as in what an anchor investor's discount costs the GP.
Valuing the proposal at the full fee saving. The LP keeps only the share not taken back as carry, 80 per cent here; it keeps all of it only if the fund ends below its hurdle and pays no carry. The second mistake, on the GP side, is to approve a budget that covers this fund but not the next fundraise: when salaries for the team that raises Fund IV are charged to Fund III's budget, LPs will challenge them, and the firm needs the margin it has just given up. Model both the fund and the management company, as in the total fee over a fund's life.
Subtract the budget from the conventional fee year by year, multiply by one minus the carry rate, and check the fund size against the budget. Here the LPs gain 11.05 and 0.033x of net TVPI on a $600m fund, while a $300m fund would be worse off. The measures an LP uses to judge the result are worked through in the free workbook for Private Equity Investor Relations.
A fee set each year at the firm's approved operating budget for the fund, salaries, rent, travel and systems, instead of a percentage of commitments or invested capital. In the illustrative $600m fund it is $9.0m in year 1 growing 3 per cent a year, against $12.0m a year at 2 per cent, so the firm earns no profit on the fee and relies on carried interest.
No. They cost less only when the percentage fee exceeds the real cost of running the fund, which happens on larger funds. A $9.0m budget equals 2 per cent of a $450m fund; on an illustrative $300m fund with a $6.5m budget, the budget is 2.17 per cent of commitments and LPs would pay $4.51m more over the investment period.
Less than the fee saving, because carry takes a share of the extra profit. In the illustrative fund, cutting total fees by $13.82m reduces paid-in capital by the same amount, raises carry by $2.76m and lifts LP profit by $11.05m, so net TVPI rises from 1.576x to 1.609x on a 2.0x gross result.
This article is one calculation from Private Equity Investor Relations. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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