Why does the “management fee base” issue even matter?
In the grand scheme of Life, the Universe and Everything, it doesn’t really matter how a management fee is calculated: great (and lucky) investors create great net returns; bad (and unlucky) ones do not. A variation in management fee base is clearly less important than the quality of the fund manager.
But on the margin things are not that simple.
First: Disturbingly often, investors pay these fees – and I mean pay them and don’t get them back again.
The theory is that an investor sees management fees repaid out of proceeds from investments, before carried interest (the share of the profits on a fund, and supposedly the main source of compensation for fund managers) gets paid.
The reality is that in a disturbing proportion of cases – because median returns to VCs are not that high – funds do not, or only just, return their invested capital. In that situation, the paid management fees remain with the poorly-performing fund manager.
In the Litvak article cited previously, “an average VC received about half of [its] compensation from the management fee, which…is either completely or largely unaffected by fund performance.” So as you look at a “downside return” case, you should care because this likely is money you won’t see again. The higher the fees, the bigger the deficit.
Second: every dollar from a fund that pays, or reserves to pay future, fees means one less dollar invested. If 20-25% of a fund doesn’t get invested, it’s a lot harder to generate a 3x net ROI to investors. You need to resort to other techniques (e.g. recycling proceeds) to make up the gap; techniques that (worst case) add even more risk to an already-risky proposition or (best case) delay your cash distributions.
Thirdly: less numerically, but still importantly, you need to understand your fund manager’s mindset. A 2% step-down fee covers the costs of running most funds, except arguably at the very smallest (<$5M) sizes. If the fund manager is paid more generously, why are they entitled to the more generous sum? Can you really believe someone with the 2% “traditional” flat fee – paid regardless of performance or how the fund goes – is going to hustle, work hard, and operate in your best interest?