On the investor side, those with available capital can exercise their bargaining strength in a more challenging fundraising environment. On the manager side, megafunds, consolidation and increased competition are all signs of a mature market where, particularly in certain areas, differentiation is becoming difficult with the result that there is more emphasis on volume and cost.
In our practice, direct lending fund fee structures is a hot topic, with varying perspectives from both investors and managers. Our view is that there will not be a single answer, but rather a continuation of what feels like a proliferation of different terms, which in some cases will be provided to investors as optionality.
In this article we analyse how different bases for calculating manager remuneration and different combinations thereof create optionality for managers and their investors.1
This article is mainly focused on drawdown, self-liquidating direct lending funds. We will consider the extra considerations that apply to evergreen funds in a second article, including the importance in terms of both manager and investor economics of those funds starting and remaining “ramped”.
In order to compare different potential approaches to fee structures, we first look at the typical fee structure of an unlevered2 closed ended drawdown direct lending fund to establish a base case.
Based on the base case assumptions we can see how, over the life of the fund, manager income is broadly split 50/50 between management fee and performance fee.
It can be seen in this base case how over half of the manager’s income (and all of the performance fee) is received in the last two years of the fund life.
Pressure on management fees is not a new topic across private capital asset classes. Power naturally shifts back and forth between investors and managers and the management fee is often the first commercial term that is tweaked to reflect this dynamic.
Although some of the reasons for current pressure on management fees are cyclical, such as the more difficult fundraising environment, others are more structural, such as consolidation and growth in fund sizes – average fund sizes across private debt have increased from approximately $600m in 2019 to over $1bn in 2024.10
Interestingly, only a slight downward trend in headline fees in the last 10 years can be identified meaning most of these negotiations are happening through side letters, making them more opaque. Discounts for early commitments, large commitments and loyalty to the manager are now widely used and we see both an increase in discount percentages and a decrease in the minimum commitments required to achieve such discounts. This is not limited to private credit; in private equity, discounts have also led negotiated management fees to be on average 25 basis points lower than the headline figures.
In our second scenario, we assume that increased pressure from investors leads to a lowering of the management fees by 25 basis points. Assuming the underlying fund performance is consistent with the base case scenario, this would generate an additional Net IRR of 0.27% bringing it to a total of 9.85%. The reduction in management fees implies that the manager income is now proportionately more dependent on performance fees when compared to management fees and the total payout to the manager would drop by c.11%. To maintain a similar total income to the base case, the fund would need to increase its performance from 11.77% gross IRR to 14.01% which would require an increase in lending spreads of approximately 200–250 basis points which would reflect a risk profile which is not typically seen within the direct lending space.
Some fund managers may be open to negotiating a reduction in their management fees for new funds in exchange for a share of the arrangement fees.
To illustrate this, we examine the impact on manager income when management fees are reduced from 1% to 0.75%. By securing approximately 15% of the arrangement fees, the manager can achieve a total income comparable to the base scenario as illustrated in in Scenario 3.
Scenario 3 results in the following fee split:
In many ways such a shift would be optical only, with a share of arrangement fees economically mirroring a management fee on invested capital in many ways. However, a share of arrangement fees can represent a cash flow boost for managers and a different ultimate amount depending on how long the loan remains unpaid.
Over the past year, some private credit fund managers have launched funds without performance fees. This has mostly been seen in the context of evergreen funds which, unlike closed ended traditional funds, are not constrained by a finite lifespan.
There are reasons for removing performance fees from evergreen funds including:
We will return to the economics of evergreen funds in our next article. For now, we will consider the impact of the removal of the performance fee on a drawdown/self-liquidating direct lending fund. Accordingly, in Scenario 4, the fund has a drawdown/self-liquidating structure. As can be seen, to return the same outcome for the manager, the management fee needs to increase from 1% to 1.3% and the fund size needs to increase from £800m to £1.2bn. With the manager relying on greater AUM to retain the same economics, the cost to the investors reduces.
In Scenario 4, if the fund size were to remain the same as the base case (i.e. £800m), management fees would be required to increase to approximately 2% to deliver a comparable total manager income in this scenario without performance fees. A 2% management fee would be seen as commercially unviable within direct lending. As such, in a drawdown/self-liquidating fund, a zero performance fee structure can only deliver equivalent economics through economics of scale.
Investors views on performance fees can vary considerably with some investors stating they would prefer to pay higher performance fees and lower management fees and others saying the polar opposite. In the UK, for example, we see particular pressure on performance fees for managers trying to break into the defined contribution pension market, where NEST, the largest master trust in the UK, has publicly stated it is not paying any carry on its private market investments.
The removal of performance fees can be particularly attractive to investors that are more sensitive to headline fee levels or that struggle with performance/cost attribution, as is the case with defined contribution pension schemes. Fund managers looking to gain market share and appeal to new investors such as retail investors and private wealth management clients may find this approach effective.
Other investors see performance fees as critical for manager incentive and alignment of interests. While in private credit, the concept of outperformance does not apply in the same way as it does in private equity, the value that private credit managers bring is exactly the ability to source deals with superior risk adjusted returns and the robust underwriting and enforcement that allow them to take on additional risk. Being able to do so requires talented managers that are compensated, at the end of a fund’s life, based on their performance.
As private credit has grown so have product innovations, which encompass deployment strategies, structures and terms. We see a proliferation of commercial terms which, at an industry-level, are increasing pressure on managers to justify their proposed costs. Particularly in the less differentiated segments of private credit, differentiation on price or other commercial terms is becoming more relevant. Interestingly, it seems to be both the largest and the newest managers leading the way on fee innovation. For the largest managers, this is made possible through economies of scale and the prioritisation of acquiring market share and penetrating new investor bases. For new entrants, their advantage is that they are not encumbered by legacy funds and have an opportunity to stand out to investors.
Fund managers may decide to offer a selection of fee structures for their funds to appeal to different investor bases. We have illustrated this in Scenario 5 where we include two extra options in addition to the base case with varying management and performance fees. The three options provide a comparable total manager income under the same performance assumptions, but the breakdown of the income into management fees and performance fees is greatly different.
For option 3, approximately 77% of manager income derives from management fees. Investors would benefit from selecting option 3 if the fund outperforms the expectations that have been assumed in this analysis as they would receive a significantly higher share of the profit. For example, if base rates fall more slowly than currently expected by market forecasts or if direct lending spreads widen then option 3 would be beneficial to the investors.
However, option 1 with lower management fees and a higher performance fee for managers would benefit investors compared to options 2 and 3 in the case of more adverse movements in base rates, lending spreads or default rates.
These options result in similar costs to investors but option 1 has a higher net IRR due to a greater portion of the cost to investors being incurred later in the fund life and therefore having a lower present value.
