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Managers of closed-end private funds (private, equity, real estate, natural resources) often negotiate management fee discounts with cornerstone or other large investors in the fund.  How do these discounts get implemented when the fund documents provide that the fund will call capital—including for purposes of paying management fees—pro rata from investors according to their capital commitments to the fund?

There are several approaches that we see taken. First, the investor can negotiate a side letter provision allowing the investor to reduce its capital contributions made to the fund for purposes of paying fund management fees, to the extent necessary to honor the fee reduction.  This approach has the benefit of allowing the investor to altogether avoid excess capital contributions to pay fund management fees.  However, it also results in the fund calling capital from certain investors for certain purposes on a non-pro rata basis.  The bookkeeping and other administrative complexities involved with non-pro rata capital calls can lead to errors in waterfall calculations and ultimately distributions. 

Second, the side letter can provide that excess capital called by the fund from the investor to pay fund management fees (as a result of the investor’s negotiated management fee discount) will be rebated to the investor periodically in the form of a special distribution, as and when normal distributions are made to fund investors.  One drawback to this approach is that for many closed end funds, management fees tend to be higher and distributions lower during the earlier years of the fund.  Therefore, the investor may experience a significant wait for these catch-up management fee rebates, at the very times when the rebates would likely be highest.  Also, just as with non-pro rata capital contributions, making non-pro rata distributions to investors can lead to accounting complexity and the opportunity for mistakes to occur in the calculation of the investor’s distributions. 

Third, the investor can simply live with the situation by allowing these excess capital contributions to be returned under the fund’s regular distribution waterfall.  The result will be that the investor is regularly contributing capital in excess of its management fee, but it is also generally earning a priority return on this excess capital just as with other capital it contributes.  This approach has the merit of being simple and not complicating the normal contribution and distribution process.  However, many investors react negatively to making unnecessary capital contributions that are then tied up indefinitely.  Many of these investors may also feel like they want a higher return than the priority return established in the fund governing documents for tying up their capital in a long-term, non-liquid investment vehicle.

One approach we have found that many institutional investors favor is embodied in the following side letter language:

“To the extent that the Investor contributes capital to the Partnership pursuant to one or more Call Notices for Call Amounts in respect of Management Fees in excess of the amount to which the Investor is obligated to bear pursuant to paragraph 10 hereof, the Partnership shall make a special distribution to the Investor annually on or about January 15 in an aggregate amount necessary to return to the Investor such excess.”

The special annual distribution to rebate excess capital called for fund management fees has the advantages of both prompt return of this capital to the investor and not complicating the ordinary capital call or distribution process.  It also allows for a clear, fixed annual payment date that can be calendared by the institutional investor’s operations team so that there can be prompt follow up if not received on a timely basis from the fund.

Media Contact

Luis F. Ruiz

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