Through the course of our work in the investment industry, we discuss fee calculations with both investment managers and investors on a regular basis. We have several clients who have engaged us to perform fee recalculations on their behalf, and we have seen an increase in the number of institutional investors who are looking to gain some comfort that they are being charged the correct fees.

As a result of these discussions, here is a list of the top five items to consider when embarking on a plan to verify investment management fees, performance fees, and other expenses.

1.Pace yourself.

A plan may have 200+ private equity mandates, managed by 100+ investment managers. That does not mean that you need to test all of the investments in the first year. We recommend that you consider prioritizing investment managers for testing. Focus first on the riskier mandates, then develop a plan to cycle through all of the investment mandates, which may take several years.

Some of the items to consider when prioritizing investment mandates for recalculation may include:

• Larger investments in terms of commitments: These provide increased coverage for total fees.
• Older/more mature investments: These tend to have the more complex fee provisions applying. Typically, the more complex provisions of waterfall and other fee calculation methodologies become relevant further into an investment fund’s life.
• Funds in liquidation mode: This may offer the opportunity to recover fund decreases prior to fund liquidation.
• More complex formulas: These offer more opportunity for miscalculation.
• Funds with specific concerns regarding investment management fees and/or carried interest
• Funds with side letters that change fee terms: We have noted several instances in which side letters that change a client’s fee structure were not incorporated into the managers’ fee calculations. We have also noted that many managers struggle with how to track the terms of all of their investors’ side letters.

It is important to note that the risk categories are necessarily subjective, and designed to identify and focus on the riskier investment mandates. Sampling a subset of managers will provide feedback to investors more quickly and provide an opportunity to revise to the plan as you go along, rather than all at once.

2.Decide whether to review or recalculate.

There are generally two different methodologies to recalculate fees, and the level of effort required to complete them varies significantly. It is important to determine whether you would like to:

• Review the investment manager’s calculation of management and incentive allocations for reasonableness in connection with the fee methodologies described in the organizational documents, or in the investment management agreement. This method requires less effort, as there is no need to develop an independent model. The drawback with this model is that agreements often require interpretation and the reviewer may become biased by the way the manager interprets the contract after seeing the manager’s calculation, rather than developing their own model to recalculate the fees based on the terms, as understood, by the person performing the recalculation.
• Recalculate the management fees and incentive allocations using supporting documents. Under this method, the fees are recalculated using the relevant legal documents and capital call and distribution notices, since inception of the investment. This method is more time-consuming, as it requires the creation of a model to calculate the fees based on the legal documents, and is more likely to uncover any inconsistencies between the investment managers’ calculations and the legal agreements.

3.Determine the scope of fees to be included.

In determining the scope of fee recalculations it is important to determine what risks are important to the investor, and then determine what fees will be recalculated. Most commonly, it is management and incentive fees. Additional fees may include expenses charged to the funds and offsets, or credits given to the investor for fees charged by a general partner to portfolio companies.

Testing expense offsets is more difficult than it may appear to be. Consider an investor’s perspective on expense offsets. The general partner may be receiving compensation from a portfolio company, and this compensation should be offset against the management fees charged to the limited partners. As a result, investors focusing on expense offsets should concentrate on the completeness of the expense offsets, and procedures should focus on finding compensation where the investor has not been given credit.

For private equity, many of the investments may be in privately-held companies where there may be non-disclosure agreements in place that prohibit distribution of certain information, including the portfolio companies’ annual audited financial statements. Some investment managers may permit an investor to read these statements, but it must be done at the investment managers’ locations and copies of these documents cannot be retained by the investor or its representative.

4.Establish a realistic timeline.

A reasonable timeline with regularly scheduled updates is critical in ensuring that the project reaches completion. When developing a timeline, it is important to note that the managers will require a fair amount of time to gather the needed information (capital call notices, partners’ capital statements, etc), and this information likely goes back to inception of the investment mandate, which may be 10 years or more. It may take investment managers several weeks to gather the necessary information, and it may take several more weeks to reconcile any variances in the calculations.

5.Consider a materiality threshold.

As auditors, materiality is a concept that we are familiar with. To put it simply, there is a point where the additional effort required to reconcile a difference between the independent calculation and the investment manager’s calculation is not worth the benefit that would be derived. This difference is likely an aggregate variance over the life of the investment. Establishing such a threshold will reduce the amount of effort required at completion of the engagement to reconcile differences with the investment managers, while focusing on the larger variances.

Fee recalculations seem like a straight-forward concept. In practice, the fee structures of investments vary greatly from investment to investment, and the only way to be certain that an investor is being charged correctly is to recalculate them. Considering the five items discussed above should help ensure the success of any recalculation project.

We would be pleased to provide further information related to this subject. For more information, contact Todd E. Crouthamel, Director, Audit & Accounting at tcrouthamel@kmco.com.  

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