The step-down approach is, in our opinion, the most appropriate management fee base.
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It provides appropriate resources to pay for deploying the capital well, based on the amount that has to be deployed at the beginning.
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The resources reduce once investments are deployed and work moves to monitoring, which still takes time and effort (adding value isn’t easy, you know), but arguably not as much as diligence and deal structuring.
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And the resources fall further still as the portfolio reduces in size and time requirements.
However, it is not perfect. If you are thinking in detail, you might have identified a couple more areas where it creates bad incentives.
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An obvious danger is that an unscrupulous fund manager wants to keep the investment period open as long as possible, to milk maximum management fee by keeping the base on committed capital.
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A second bad incentive is to raise capital that can’t be deployed quickly. Although there are definitely merits to including “temporal diversity” (i.e. investing in vintages over time, as well as in geography, industry, fund managers, etc.), you can’t invest by leaving cash in the bank earning 0.01% interest (and -2% management fee). Fund managers might raise more money than they can actually deploy to maximize the fees.
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A third bad incentive inherent in the step-down approach is to delay writing off invested capital. The 2% applies to net invested capital; the “net” means the base is reduced by the cash invested in companies that have been written off. A fund manager might delay write-offs to keep collecting the fees.
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Lastly, fee gouging. A Limited Partnership Agreement for a venture capital fund might include something like this: “The Fund shall also bear legal, audit and accounting, banking, and financial fees and expenses of the Fund; expenses relating to the Fund’s portfolio (i.e., interest on borrowed money, brokerage, registration of securities); and any extraordinary expenses of the Fund.” You might (justifiably) wonder why these fees aren’t part of the management fee. This applies to all bases, of course, but you might think managers using a step-down approach are more likely to layer these fees on top because they have fewer resources. Could be true.
What can an investor do about these things?
Perhaps not much in many cases, beyond doing your diligence and trying to work with reasonable fund managers!
However, remember that all this bad behavior would pale in comparison to taking the much higher flat fee! Even if a manager did as much as possible to maximize management fees on 1-3 above, they still couldn’t get above the 20% total load from the traditional approach from the last post! So perhaps sticking to managers that use step-down approaches would be sensible?