The Management Fee, and What It Actually Pays For

A management fee is an operating budget, not a reward for performance. ILPA Principles 3.0 say it should rest on the normal operating costs of the fund, and that salaries, overhead, compliance and office costs belong to the manager, not the partnership. In a two-partner firm, the fee is best read one function at a time, then against the step-downs and offsets that shrink it.

01The Operating Budget Principle

The Institutional Limited Partners Association states the principle in one sentence: the management fee should be based on reasonable expenses related to the normal operating costs of the fund. The same section adds that the rationale for the fee should be apparent to limited partners, because excessive fees create a misalignment of interests. Carried interest is the performance reward. The fee keeps the manager open, staffed and compliant while the portfolio is built and harvested. The distinction is set out further in carried interest.

ILPA then draws the boundary that matters most to an allocator. Overhead costs, salaries of the general partner's employees and any relevant advisers or affiliates, travel and other costs should be borne by the manager under the management fee rather than allocated to the fund. Its examples are specific: industry conferences, research and information services, software and subscriptions, travel and lodging, investment consultants, maintenance of required books and records, regulatory compliance and registration, remedial work after a regulatory examination, and office space, computers, telephones and utilities.

For first-time funds, or funds with a higher than average fee, ILPA asks the general partner to provide a budget that lays out the rationale for the fee proposed, and asks every manager forming a new fund to provide a fee model showing how fees will be calculated over the life of the fund. That request applies with most force to a small or first-time manager, discussed in emerging manager, and the budget becomes the document in which the fee is tested.

02The Fee-Budget Table

The table sets out what a management fee funds in a two-partner firm, function by function. It assigns no dollars to any firm. The third column states where ILPA Principles 3.0 place each cost; where the answer turns on drafting, the limited partnership agreement governs.

Two rows carry particular weight in life sciences. Early clinical, regulatory and reimbursement work is expensive, and under ILPA's allocation it is a cost of finding deals, paid from the fee. Operating expertise is the second; the arrangements are examined in operating partner.

03Step-Downs and Offsets

A fee is quoted as a rate on a base, and the base moves. The Division of Examinations described the convention in its January 27, 2022 risk alert: private equity advisers typically charge a percentage of commitments while the fund deploys capital, and the base is generally reduced afterward to invested capital, less dispositions, write-downs and write-offs. Cambridge Associates reports that management fees generally ranged from 1.0% to 2.5% of commitments in the funds it reviewed. The items below are market convention and ILPA guidance, not the terms of any particular manager.

1. Investment-period base. Committed capital is the convention. ILPA asks managers to test a commitment-based fee against operating costs and suggests that the parties consider a bifurcated fee that blends committed and invested capital.
2. Step-down after the investment period. Cambridge Associates identifies three approaches: a lower rate on commitments, the same rate on invested capital, or both. Growth equity funds in its 2022 sample most commonly changed the basis to invested capital, with rate reduction a close second. ILPA asks that the fee step down to a percentage of unrealized cost.
3. Successor fund. ILPA states that fees should reflect the lower expenses incidental to forming a follow-on fund and should step down significantly when one is formed, and that a manager of predecessor funds should consider basing the follow-on fund's initial fee on invested rather than committed capital.
4. Term extension. ILPA's position is that no fee is charged during an extension unless limited partners agree to one.
5. Portfolio company fee offset. ILPA asks that portfolio company fees be 100% offset against the management fee and that exemptions be rare and clearly defined. Cambridge Associates calls a dollar-for-dollar offset of advisory and transaction fees exceedingly common.
6. Single-investor fee cap. Where one investor negotiates a cap, ILPA asks that the manager absorb the difference, so that none of it is loaded onto the remaining investors.

The Commission's examination staff has found several of these mechanisms misapplied. Its June 23, 2020 risk alert reported advisers that failed to apply or calculate fee offsets in accordance with disclosures, and advisers that charged funds for adviser-related expenses such as salaries, compliance, regulatory filings and office expenses not permitted by the fund documents. The 2022 alert reported advisers that did not reduce the cost basis after selling, writing off or writing down an investment, that used undefined terms such as "impaired" without consistent procedures, and that extended fund terms without required approvals.

04The Disclosure Standard

The legal frame is antifraud, not rate regulation. Section 206 of the Investment Advisers Act, 15 U.S.C. 80b-6, makes it unlawful for any investment adviser to employ a scheme to defraud a client or prospective client, or to engage in any practice that operates as a fraud or deceit. Rule 206(4)-8 carries the prohibition through to the investors themselves, reaching untrue or misleading statements of material fact made to any investor or prospective investor in a pooled investment vehicle. The 2020 risk alert characterized the fee and expense findings above as apparent deficiencies under Section 206 or Rule 206(4)-8.

The Commission's Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA-5248, issued June 5, 2019, sets the disclosure bar. To meet its duty of loyalty, an adviser must make full and fair disclosure of all material facts relating to the advisory relationship. The release states that disclosing that an adviser "may" have a conflict is not adequate when the conflict actually exists, that disclosure must be specific enough for informed consent, and that disclosure and consent do not by themselves satisfy the duty to act in the client's best interest.

For a registered adviser, the brochure carries the fee. Form ADV Part 2A, Item 5, requires a description of how the adviser is compensated, a fee schedule, whether fees are negotiable, whether fees are deducted or billed and how often, other fees and expenses clients may pay, and the treatment of fees paid in advance. An SEC-registered adviser need not include the Item 5.A information in a brochure delivered only to qualified purchasers, so for many private funds the operative fee terms sit in the partnership agreement and offering documents, and the antifraud standard applies to those documents.

The 2023 private fund adviser rules, which included a quarterly statement rule on fees and expenses, did not survive. The Fifth Circuit vacated the final rule in its entirety on June 5, 2024 in National Association of Private Fund Managers v. SEC, No. 23-60471. Fee disclosure therefore rests on Section 206, Rule 206(4)-8, the 2019 interpretation, Form ADV and the fund documents themselves.

05The Budget as the Test

A fee is defensible when each function in the table can be named, staffed and paid for, and when the step-down and offset provisions return the surplus once the work declines. The fee model ILPA asks for shows the second point. A budget shows the first. Read together, they tell an allocator whether a fee funds a firm or a margin.

The position taken here is a judgment, not a sourced finding: in a two-partner life sciences manager, compliance and specialist diligence are the functions most easily underfunded, because neither shows up in returns until something goes wrong. A budget that names both, alongside the people who perform them, is the clearest evidence that the fee is doing what ILPA says it is for. The broader structure of the strategy is set out in growth equity.

06Frequently asked questions

What does a private equity management fee pay for?

Under ILPA Principles 3.0, the fee should rest on the normal operating costs of the fund: salaries of the manager's employees and advisers, overhead, travel, research, compliance and registration, books and records, and office costs. Those costs are borne by the manager under the fee and are not charged to the fund. Broken deal expenses and organization costs up to an agreed cap are usually fund expenses.

What is a management fee step-down?

A step-down reduces the fee after the investment period. Cambridge Associates identifies three market approaches: a lower rate on committed capital, the same rate on invested capital, or a combination. ILPA Principles 3.0 ask that the fee step down to a percentage of unrealized cost, and step down significantly when a successor vehicle is formed or the term is extended.

Which rules govern management fee disclosure?

Section 206 of the Investment Advisers Act and Rule 206(4)-8 prohibit fraudulent and misleading conduct toward clients and toward investors in pooled vehicles. The SEC's 2019 interpretation, Release No. IA-5248, requires full and fair disclosure of all material facts relating to the advisory relationship, and Form ADV Part 2A, Item 5, sets out the brochure's fee disclosures for registered advisers.

Nothing in this piece is investment, legal, tax or accounting advice, and nothing in it is an offer to sell or a solicitation of an offer to buy any security.