Managing Complex Fee Calculations

Fee transparency and accuracy are essential for building trust between investment advisers and investors. For investors, understanding the costs associated with certain investment services continues to be an important factor in the selection of investment advisers.

This transparency, or lack of transparency, continues to be a focus of the U.S. Securities and Exchange Commission (SEC). Recently highlighted in the April 2024 Marketing Rule Risk Alert, staff noted misleading practices include “omitting material information regarding fees and expenses used to calculate returns.”

Disclosure is not only important; the accuracy of decisions regarding fees charged to investors also remains a focal point. In the current environment of intense regulatory scrutiny, the SEC is putting private fund managers under the microscope.

SEC spotlight on fee calculations

This regulatory focus goes back as far as an December 2021 enforcement action when the SEC charged an investment adviser for not adequately offsetting management fees as stipulated in their fund documents. This led to investors overpaying millions of dollars, and it underscores the critical importance of accuracy and transparency in fee calculations. Also, the firm provided inconsistent and misleading statements about the methodologies used for calculating management and other fees.

In September 2022, an adviser was found to not be following a fund limited partner agreement (LPA) related to step down fees and the treatment of dispositions which impact the valuations used to determine fees. In a separate enforcement action in the same month, an adviser was cited over concerns to properly offset management fees according to the governing documents.

More recently, in June 2023, an adviser was cited with overcharging fees related to an impaired asset and failure to disclose the impairment criteria to investors.

We continue to see exam priorities around the calculation and allocation of private fund fees and expenses. Risk areas include:

• The process for valuation of holdings and allocation of fees and expenses
• Post commitment period management fees
• Offsets
• Adequacy of disclosures

Mitigating risks associated with complex fee structures

To mitigate risks created by implementation of complex fee structures, it is crucial for firms to establish robust, well-documented procedures and conduct testing to ensure a transparent and clear dialogue between the in-house legal team and the internal team's responsible for fee implementation. Firms can manage the additional regulatory scrutiny by adopting additional fee testing as part of a firm’s annual compliance program. Traditional separately managed account (SMA) fee structures typically include tiered management fees applied for accounts in their household. Management fees are typically charged as a percentage of their assets under management (AUM) and investors can qualify for lower rates as their assets increase in value across defined breakpoints.

Private funds, however, present a more complex fee structure with custom management fee terms and performance-based fees, such as carried interest. The intricacies of fee arrangements in private funds can pose significant risks if not carefully managed and accurately calculated.

Understanding the specific fee arrangements being applied to investors, the nuances of the calculations, and the precise wording of the agreements is crucial. Investment advisers must implement robust processes to manage these complexities effectively and ensure that fees are calculated accurately and transparently.

Understanding fee structures

Traditional SMAs: Separately managed account management fees (SMAs) usually involve a percentage-based fee structure calculated on the AUM. These fees can also be charged at a flat rate agreed upon within the client contract. The fee percentage often decreases as the size of the assets increases. This creates a tiered structure that incentivizes clients to consolidate more of their assets with the advisers and aligns the interests between both parties. These fees can range depending on the complexity of the investment strategy and the level of service provided by the adviser. When multiple portfolios are managed, advisers may consolidate defined household to contribute towards reaching higher breakpoint levels and achieving a lower overall cost of service.

Private Funds: Private funds present a more complex fee structure compared to traditional SMAs. These funds often include custom management fee terms and performance-based fees such as carried interest or promotes. The intricacies of fee arrangements in private funds can pose significant risks if not carefully managed and accurately calculated.

Understanding these fee structures is crucial for accurately assessing and mitigating the risks involved in fee calculations. Both traditional SMAs and private funds have unique challenges, and investment advisory firms must implement robust processes to manage these complexities effectively.

Top risks in the fee calculation process

Lack of transparency: When investors are not provided with clear visibility into how fees are calculated, they may be unaware of the true cost of their investment. This can lead to dissatisfaction and even prompt clients to leave their adviser in favor of another provider.

For traditional SMAs, it is essential to communicate how the fee structure works, including how clients can benefit from breakpoints. Because fees are often calculated based on total AUM or net asset value (NAV) for funds, there is an additional need for firms to substantiate a clear basis for which assets should be subject to a fee and communicate that basis to investors. For private funds, the complexity of fee structures necessitates even greater transparency. Agreements should clearly outline any assumptions made, how different thresholds such as preferred returns are calculated, and include examples to ensure both parties are in alignment.

Clear communication with investors is crucial to ensure transparency and reassure investors that their investment management firm is acting with their best interests in mind. Providing detailed explanations and examples helps articulate the fee calculation process, making it easier for clients to understand and trust the fees they are being charged.

Additionally, detailed agreements and transparent communication provide internal stakeholders with a roadmap to help assess new situations that arise throughout the life of the account or fund. This clarity helps ensure that all parties have a common understanding, reducing the risk of future disputes.

Calculation errors: Calculation errors pose a significant risk for both traditional SMAs and private funds. These errors often arise from oversight, incorrect data input, or incorrect cell references in fee calculation spreadsheets.

For SMAs, firms might overcharge clients by failing to adjust fees when their assets qualify for a reduced rate across household accounts. Incorrect data entries or formula errors can lead to charging higher fees than agreed upon. In private funds, the heavy use of Microsoft Excel for fee calculations can intensify these issues, making errors more prevalent. Complex fee structures and performance-based fees can result in significant discrepancies if data inputs are inaccurate or cell references in the calculation models are incorrect.

Inconsistent application of fee terms: Inconsistent application of fee terms can pose significant challenges for investment advisory firms leading to errors and discrepancies in fee calculations. This issue can arise from misalignment between different teams or even within the same team during transitions of responsibility. A common source of inconsistency is the gap between the legal counsel who drafts the agreements or LPAs and the finance teams responsible for calculating the fees. Legal documents can be complex and nuanced, and if the finance team does not fully understand the terms or interprets them differently than intended, it can lead to incorrect fee calculations.

In traditional SMAs, inconsistencies can occur when different team members handle householding and tiered fee breakpoints differently. One team member might include all client accounts within a household to apply the lower fee rate, while another might overlook some accounts, leading to inconsistent fees for the same household. Similarly, if tiered fee breakpoints are applied inconsistently, clients with similar asset values might be charged different fees.

In private funds, the complexity of fee structures and performance-based fees can lead to inconsistencies when terms are not clearly defined or are applied incorrectly.

For example, if the preferred return threshold defined in the LPA is vague, different team members might calculate it differently, resulting in discrepancies. Additionally, the base used to derive management fees can be a source of inconsistency. If it is not clear what is included or excluded, such as write-downs or specific types of investments, different interpretations can lead to significant variations in fee calculations.

Complexity in private fund fee agreements: In private funds, fee agreements often include specific terms or conditions that must be met for certain fees to apply. These terms are frequently referenced in multiple sections of the agreements, making a detailed understanding of the terms and definitions used throughout essential. If these conditions are not properly accounted for, it can lead to incorrect fee calculations.

For example, performance fees might only be applicable if a certain benchmark or preferred return is met. The terms for these fees may include definitions such as invested capital, average NAV, and other key metrics detailed in different sections of the LPA. This requires a comprehensive grasp of the entire document to ensure accurate interpretation and application. Failing to correctly interpret and apply these conditions can result in significant calculation errors.

Insufficient documentation: Insufficient documentation can disrupt an adviser’s ability to appropriately support the fees charged to investors, leading to misunderstandings, disputes and potentially legal action if fees charged cannot be supported. An additional complexity may exist if the contracts that could be used as support are not signed and dated by the investor. This may lead to regulatory issues that cause the SEC to act on fees historically charged. All these situations underscore the importance of clear and detailed governing documentation, which can reassure the firm that their books and records support their fee calculation process.

Mitigating risks in fee calculation

Regular fee reviews and audits: Regular fee reviews and audits can help identify any discrepancies between investor contracts and your billing system. Highlighting these differences enables your firm to proactively address potential issues before they escalate. To ensure objectivity, the compliance team or an independent team, separate from both the fee calculation team and the legal team that drafted the agreements, should conduct these reviews. This helps ensure an unbiased examination of the fee calculations. Additionally, ongoing fee reviews ensure that accounts are being appropriately charged according to their defined breakpoints, reducing the likelihood that clients will slip through the cracks due to lack of resources or staff.

Clear and comprehensive LPAs: Ensuring that LPAs are clear and comprehensive is crucial for accurate fee calculations. These agreements should explicitly define all terms and conditions, including any benchmarks, thresholds, or specific items included or excluded in fee calculations. Incorporating the finance team in the drafting process of LPAs ensures that they understand the intentions behind the terms and can provide input on the complexities of actual implementation. This collaboration allows them to offer different solutions and ensures that the terms are practical and implementable, minimizing the risk of errors.

Training and education: Implementing regular, ongoing training for staff in finance and operations is one of the best ways to mitigate the risk of inaccurate fee calculations. Educating your team on the types of fees your firm charges and any changes to the process ensures that everyone is up-to-date and capable of applying the correct procedures. This also helps clients understand what they are paying for, fostering transparency and trust.

Robust documentation and record-keeping: Maintaining detailed records for all client contracts and fee schedules is essential for protecting your firm from regulatory and legal action. A standardized documentation process increases the chances your staff will get it right the first time for all your investors. Proper record-keeping provides a clear audit trail that can be invaluable in resolving any disputes or questions about fee calculations.

Conclusion

Effective fee reviews that focus on key risk areas are essential for maintaining transparency, fairness, consistency, and regulatory compliance within investment management firms. By addressing risks such as those noted earlier, firms can significantly mitigate potential issues. Clear documentation and effective communication are critical components of this process, helping to prevent errors and misunderstandings. Prioritizing thorough fee reviews enables firms to build stronger relationships and safeguard against regulatory challenges.

How we help

ACA's Managed Performance Services solutions allows firms to leverage unparalleled expertise, scalable solutions, and significant cost savings. In addition, collaborating with us can strengthen risk mitigation, simplify the intricate investment process, and seize opportunities for growth and innovation. 

We can help firms implement a robust internal fee review audit program without the administrative overhead of managing it in-house. Our fee review process is meticulously designed to test the accuracy of your firm's fee calculation process, ensure the completeness of your books and records, and maintain operational diligence over time.

If you would like to get in touch with our team today, we're ready to help. Start a conversation with us here. 

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