Over the past two years, fund managers have been tasked with finding ways to gain efficiencies and scalability not only in their fund administration management responsibilities but also in their underlying management company operations. The firm’s overall size, fund complexity and structure, and level of in-house resources will drive your specific requirements. Third-party service providers deliver flexibility by offering a full scope of supportive or ad hoc services. At Ultimus LeverPoint, we’ve seen fund managers benefit in significant ways by outsourcing all or some of their management company operations to increase in-house capacity and gain efficiencies.
At Ultimus LeverPoint our team works in a consultative manner with private equity CFOs, Controllers, and General Partners to implement the best operating model for each firm to ensure that your management company objectives and priorities are addressed.
Outsourcing some or all the management company operations is worth pondering the operational aspects and the beneficial outsourcing options that impact growth initiatives.
Understanding the Management Company Structure
A funds management company, also known as the fund manager or asset manager, embodies the firm itself and employs the investment and financial professionals responsible for allocating capital and managing the fund’s investments. The fund manager is generally affiliated with the general partner, but they are not the same entity.
The general partner will enter into a management agreement with the management company. Under this agreement, the fund pays the management company fees to employ the investment team, evaluate opportunities, manage the portfolio, and manage all day-to-day operations. This common private equity structure allows the management company to work across multiple funds while still having a general partner for each fund.
While asset management companies are tasked with keeping the investment management business running, fund managers may want to think proactively about how a looming growth spurt will impact the management company’s ability to adequately control its operational needs. Forward-looking firms in this situation may recognize that more or larger funds bring increased operational volume and complexity, along with extra operating expenses. While this may be considered a “quality” problem, it is, nonetheless, worth weighing the operational aspects and the beneficial outsourcing options that can help with growth.
Carried Interest and Management Fees
Carried interest represents the portion of any profits provided to the general partner regardless of their initial investment (typically 20%). Limited partners also receive disbursements from any leftover profits (typically 80%). This tier represents the primary source of funding for a sponsor. In return, it’s the GP’s job to ensure that LPs receive their initial investment back, along with the agreed-upon preferred returns. The amount of the carried interest and the manner in which it is distributed will be set out in the distribution waterfall of the fund’s partnership or operating agreement.
In addition to carried interest, the management company will receive management fees which are calculated as a percentage of the fund’s total AUM, typically 1.5% – 2% of committed capital. The fee structure for private equity (PE) firms varies but typically consists of a management and performance fee. A yearly management fee of 2% of assets and 20% of gross profits upon sale of the company is common, though incentive structures can differ considerably.
This management fee is a stipulated annual percentage calculated and paid monthly. For example, if a management company charges a 2% annual management fee, it would charge about $200,000 in annual fees to manage a fund with an AUM of $10 million. Typically, although not always, as investors make capital contributions to the fund to cover management fees, there is a reduction in their unfunded capital commitment available to make investments.
Management fees are used to cover the overhead costs of a fund’s operations such as:
- Salary of management company personnel
- Health benefits to personnel
- Rent or property costs
- Day-to-day costs of operations
- Costs of monitoring existing investments
Management fees are:
- Paid in regular intervals (usually on a quarterly or semi-annual basis), whether or not an investment has been sold at the time of payment
- Typically taxed as ordinary income
- Typically paid from two principal sources: (i) the investors’ capital contributions to the fund, and (ii) the proceeds from the fund’s investments.
Key Tasks of Fund Management Companies
Management companies are tasked with keeping the firm running. As such, managers may want to think proactively about how their growth spurt will impact the management company’s ability to adequately control its operational needs.
The responsibilities of a management company are broad, and include:
- Hire and pay employees
- Engage vendors, oversee the relationships, and pay expenses
- Bill portfolio companies
- Track and monitor accounts receivable
- Handle regulatory reporting obligations
- Pay ongoing operating expenses
- Oversee the fund and fund-related expenses
In addition, fund management companies take on tasks to create an investment portfolio and open up new investment opportunities for their clients. The key tasks of a fund management company include:
- Assessing the fund’s financial goals and attitude towards risks – Management companies may require key information on how much the client wishes to invest, how much return they want, when they will need to access their money, and how much they are willing to risk losing.
- Monitoring potential investments – Investments may range from cash deposits and government bonds to shares in new companies with unpredictable outcomes. A management company must be aware of the potential investment opportunities in the financial market and calculate the risks and returns of each.
- Creating investment strategies – Each client may need an investment portfolio that matches their goals. Portfolio diversification with investments spread across many different assets and securities can also reduce risk.
Models for Outsourcing
As with most things, one size does not fit all. A management company’s size, complexity and in-house resources influence the optimal outsourcing model, from co-sourcing to partial outsourcing to full outsourcing.
Co-source – With the co-sourcing model, service providers work within the management company’s infrastructure, using their technology, processes and procedures. The important benefit: alleviating or postponing the manager’s need to hire additional employees.
Partial outsource – Management companies can choose specific tasks to outsource. For instance, outsourcing payroll adds a layer of confidentiality by limiting visibility of firm compensation. Outsourcing simultaneously reduces the workload on in-house resources.
Full outsource – Management companies can choose a turn-key solution to outsource the full range of operational responsibilities to an external provider. The firms benefit from proven expertise and technology supported by a rigorous control environment.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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