2017 PRIVATE FUND REPORT: DOES TWO and TWENTY HAVE a FUTURE? Introduction Joel A

Private Fund 2017 REPORT Does “TWO and TWENTY” Have A Future? Table of Contents Introduction Joel A. Feuer, Executive Director, Lowell Milken Institute for Business Law and Policy at UCLA School of Law ............................... 2 Private Funds Economics 101: A Short Primer on Management Fees and Performance-Based Remuneration Timothy P. Spangler, Director of Research, Lowell Milken Institute for Business Law and Policy at UCLA School of Law, and Partner, Dechert LLP ................................................................................................................................................................... 3 The Texas Teachers’ “1 Or 30” Fee Structure Jonathan P. Koerner, Partner and Head of Implementation, Albourne Partners ................................................................................ 7 Anatomy of Private Fund Fees: An Industry Insider’s View Robert S. De Leon, General Counsel and Chief Compliance Officer, Rimrock Capital Management, LLC ....................................... 11 Private Fund Fee Structure and Blockchain Applications Wulf A. Kaal, Associate Professor and Director, Private Investment Fund Institute, University of St. Thomas School of Law .......... 15 SEC Enforcement Actions Involving Private Funds and Their Advisers Eva Ciko Carmen, Managing Partner (New York office) and Co-Chief of the Securities and Futures Enforcement Group, Ropes & Gray LLP ........................................................................................................................................................................... 19 New SEC Enforcement Action Gives Force To Ongoing Safeguards Requirements Elizabeth P. Gray, Partner and Co-Chair of the Securities Enforcement Practice Group, James E. Anderson, Partner, William Stellmach, Partner and Ashley Singletary-Claffee, Associate, Willkie Farr & Gallagher LLP ............................................... 24 Contributor Biographies ............................................................................................................................................................. 26 2017 PRIVATE FUND REPORT: DOES TWO AND TWENTY HAVE A FUTURE? Introduction Joel A. Feuer, Executive Director, Lowell Milken Institute for Business Law and Policy at UCLA School of Law The Lowell Milken Institute for Business Law to a relevant benchmark index. In order to those structures are changing and may change and Policy at UCLA School of Law is pleased succeed, fund managers need access to big in the future. In addition, keeping with our to present its fourth annual Private Fund data, including esoteric databases, and must tradition for these Reports, we solicited articles Report. Our focus this year is on the structure pay the high-priced talent to scrub the data on trends in regulations and compliance. of remuneration paid by investors to fund and then analyze it quickly and accurately Short biographies of the contributors to this managers. Remuneration is about more than in order to benefit from the information. Report are set forth at the end of the Report. the total price charged to invest with a fund. For example, at a recent conference, I heard It is also one of the most important markers a fund manager discuss the cost and efforts Our 2017 Private Fund Report: Does for determining alignment of interests required by the fund’s analysts to review and “Two and Twenty” Have A Future? and between the investors and the fund managers. analyze satellite photos of mall parking lots companion Private Fund Conference on May Thus, the long-time “two and twenty” in connection with their investment decisions 18, 2017 at UCLA School of Law are intended structure in which investors pay an annual relative to mall owners. to provide a forum for a conversation about the 2% management fee on funds invested and many and important issues surrounding private 20% success fee on profits obtained (or For this year’s Report, we solicited articles fund remuneration and alignment of interests some variation) has been under attack as too from participants in and knowledgeable between investors and fund managers. We expensive and favoring the interests of fund observers of the private fund industry and look forward to your participation. And, we managers over the interests of the investors. asked them to consider the issues that thank our sponsor for the 2017 Private Fund Yet, at the same time, fund managers are surround remuneration structures. We were Conference, the law firm of Andrews Kurth finding it increasingly expensive to deliver interested in both the existing remuneration Kenyon LLP. alpha, the excess returns of a fund relative structures and in the current thinking of how 2017 PRIVATE FUND REPORT: DOES TWO AND TWENTY HAVE A FUTURE? 2 associated with identifying and executing the Private Funds Economics 101: various transactions (in the case of a hedge A Short Primer on Management Fees and fund, for example, brokerage commissions) will be charged to the fund and its investors Performance-Based Remuneration as well, rather than being paid by the fund Timothy P. Spangler, Director of Research, Lowell Milken Institute for Business Law manager. and Policy at UCLA School of Law, and Partner, Dechert LLP Different types of funds approach the mechanics of calculating and paying these fees Hedge fund and private equity fund investors its investors) based on the size of its assets. In in slightly different ways. In a hedge fund, can earn high returns on their investment addition, performance-based remuneration to ensure that fees are only paid on money when these funds outperform the market. On is payable on increases in the investments actually at work, mechanisms are put in place these high returns fund managers will typically value over time. The particular percentage of to take into account fund subscriptions and take a portion of profit and as a result will gain or profit reallocated to the fund manager redemptions within the quarter. For private be highly rewarded for the success that they will vary, but 20% has emerged as a de facto equity funds, with drawdown and harvest bring investors. However, regardless of how standard across a variety of asset classes. A of potential investments within a particular the funds perform, these same managers also typical private equity or hedge fund will earn investment period, it is common to see take a recurring management fee based on a 2% annual management fee, paid against the management fee be charged, after the the amount of money entrusted to them by the assets in the fund, as well as a 20% profit investment period has passed, only on actually their investors. This fee is payable regardless participation, this is often known as “Two and invested capital. As a result, the total amount of whether the fund has performed well and Twenty.” payable decreases as underlying investments regardless of whether there were any profits to are harvested. In addition, management fee be shared with the manager. rates might also decline upon the launch by Management Fees the fund manager of a follow-on fund. This is In recent years, questions have been raised Management fees are calculated in reference due to the additional revenue stream coming in about whether these two separate streams to the entire sum of money in, or committed from the new commitments obtained, often by of revenue adequately align the interests of to, a fund and are typically paid quarterly. many of the same investors who have manager and investor, or instead undermine Traditionally designed to permit the struggling “re-uped” into the new fund. the ability of investors to earn returns manager to “keep the lights on” until the commensurate with the risks they are taking performance fees are paid, a 2% management Given the significant sums of money that can when they invest in volatile hedge fund and fee has been for many years the de facto be paid by investors as the years go by, limits private equity fund strategies. standard for private equity and hedge funds. on and carve-outs to management fees have However, with the rise of “mega funds” and evolved to protect investors. For example, Even though the headline rates are often the the continued presence of significantly smaller management fees are frequently offset by initial focus of negotiations between fund start-up managers entering the market to focus other revenue received by the fund manager managers and fund investors, the actual on niche opportunities, 2% is often too large in connection with the fund’s operation. In the rapidly evolving world of modern finance, The math is straight-forward and compelling. For a $1 billion fund a there are a surprising number of ways Wall Street investment bankers have devised to get 2% management fee would see the fund manager earn $20 million every year, paid along the way while a deal is getting done. regardless of whether the investment strategy actually performs. Many of these payment streams have migrated into private equity deal-making, including transaction fees, monitoring fees, investment mechanics contained in the underlying legal for large funds and too small for small funds. banking fees, director’s fees and break-up fees. documentation for calculating these amounts The math is straight-forward and compelling. The receipt of these additional revenue streams are now also receiving increased attention. To For a $1 billion fund a 2% management creates a potential conflict of interest requiring understand the forces currently driving fees in

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