The annual charge is read for its base and its step-down before its rate.

The annual charge the manager draws from a closed-ended fund is stated as a rate, and the rate is negotiated. Two other terms decide what it amounts to over the fund's life, and a register reads them before it argues about the rate. The first is the base: the amount the rate is applied to, which is total commitments during the investment period in most constitutions and invested capital afterwards. The second is the step-down: the date and the mechanism by which the base changes from the first to the second, and the rate itself may fall at the same time. A rate applied to commitments for ten years and the same rate applied to commitments for four years and to invested capital for six are different sums, and the difference on a fund of ordinary size is a multiple of the rate's last decimal place. The rate is the visible term; the base and the step-down are the charge.

This note sets out what the charge is for, the two bases and what each measures, the step-down's trigger and mechanism, the definition of invested capital, the treatment of write-downs and realisations, the charge during extensions and after the term, the offset of transaction income, the charge on co-investment and parallel vehicles, the lender's reading, the onshore vehicles' own charges, a comparison, a worked charge as a type, cases, what each party holds, the sequence, questions, terms and what to read.

What the charge is for

The charge pays for the manager's running costs: its people, its premises, its systems, its diligence on positions it does not buy, its regulatory standing. It is not a reward for performance, which the carry is, and a charge set to produce a profit for the manager is a charge the register reads as a second carry. Managers describe the charge as covering costs, and a register that asks for the manager's budget reads whether it does. The charge's level over the fund's life, on its base and with its step-down, is the number the budget is read against.

The two bases

During the investment period the manager is finding, diligencing and buying positions, and its work is proportional to the fund it must deploy, which is the commitments. The charge runs on total commitments, drawn or not. After the investment period the manager is managing and selling what it bought, and its work is proportional to what it holds, which is invested capital. The charge runs on invested capital, and as positions are sold the base falls. The two bases measure two kinds of work, and a constitution that runs the charge on commitments for the whole life pays the manager for deployment work it is no longer doing.

Why the rate is read first

The rate is one number on the term sheet, the base and the step-down are clauses in the constitution, and a register compares funds by the number. Managers know it, and a manager that wants a higher charge over the life offers a lower rate on a longer commitments base, or a rate with a floor, or an invested capital definition that does not fall. The register that reads only the rate accepts the terms in the clauses, and the clauses set the charge. The reading order this note proposes inverts the term sheet's: the base, the trigger, the definition and the offset first, and the rate as the last term, negotiated on the others.

The arithmetic over a life

Take a fund with a four-year investment period and a ten-year term, fully drawn by the fourth year, that sells a quarter of its positions by cost in each of years six to nine and writes one down in year five. On a commitments base for the whole life the charge is the rate on total commitments for ten years. On a commitments base for four years and an invested capital base thereafter, net of the write-down and the realisations, the charge in year five is the rate on drawn cost less the write-down, and in years six to nine it falls by a quarter each year, and in year ten it is on the last quarter. The second sum is a fraction of the first, and the fraction depends on the write-down reduction and the realisation pace more than on the rate. A register that computes both sums before negotiating the rate knows what the rate is worth.

The investment period's end by date

The investment period ends by date at a period from the first or final close, and the choice of close matters: a period from the final close on a fund whose final close is eighteen months after its first gives the manager eighteen months more on the commitments base. The constitution fixes the period and the close, and a register reads which close. An extension of the investment period, by the manager with the committee's consent, extends the commitments base, and the constitution says whether the manager may seek it and on what showing.

The step-down's trigger

The step-down happens on a date or on an event. The date is the end of the investment period as the constitution fixes it, usually a period from the first or final close. The event is the earlier of that date and something else: the fund being substantially invested, the manager's successor fund holding its first close, a key-person event, or the manager's election to end the period early. The event trigger matters because a manager that raises its next fund while this fund's investment period runs is paid on commitments by two funds for the same people, and the successor-fund trigger ends that. A register reads the trigger for whether it has the successor-fund term.

The step-down's mechanism

At the step-down the base changes, and the rate may change too. The usual forms: the same rate on invested capital; a lower rate on invested capital; a rate on invested capital with a floor, so that the charge does not fall below a sum that keeps the manager running; or a rate on invested capital that falls further at stated years. A floor is a commitments charge under another name if it is set near the commitments charge, and the register reads the floor against the invested capital the fund is likely to hold. A step-down with no floor on a fund that sells early leaves the manager with a charge that does not cover its costs in the fund's last years, which is the register's problem too, because a manager that cannot afford to run the fund runs it badly.

Invested capital, defined

Invested capital is the cost of positions held, and the definition decides the charge. It includes the acquisition cost of each position; the constitution says whether it includes transaction costs, follow-on investments, capitalised costs of the onshore vehicles, and amounts drawn for charges and expenses. It is reduced by realisations, and the constitution says whether a partial realisation reduces it by the cost of the part sold or pro rata. It is reduced, or not, by write-downs, and that is the term that matters most: a position written down to nothing that still carries its cost in the base is a position the manager is paid to hold at its original size. A definition that reduces the base by permanent write-downs, as determined by the valuer, is the register's term; one that does not is the manager's.

Write-downs and realisations

A write-down reduces the base if the constitution says so and by the amount the valuer determines; a subsequent write-up may restore it. A realisation reduces the base by the cost of what was sold, from the date of sale, and the administrator computes the base at each charge date. A position sold at a loss reduces the base by its cost, not by its proceeds, so that the manager is not paid on the loss. The administrator's computation carries, at each date, the cost of each position held and the adjustments, and the committee reads it.

Extensions and after the term

The fund's term may be extended, by the manager with the committee's or the register's consent, for a period to allow remaining positions to be sold. The constitution says what the charge is during an extension: the same, reduced, or none, or a fixed sum for the work of selling. A manager with a charge on invested capital during an extension is paid to hold, and a register that wants the positions sold reads the extension charge for the incentive it creates. After the term, in liquidation, the charge is the liquidator's or a fixed sum, and the constitution says so.

The charge and the hurdle

The charge is drawn from commitments and is part of the contributed capital on which the hurdle runs, so that the register's preferred return is computed on what it paid the manager as well as on what the manager invested. That is the usual position and it is the register's: the charge is the register's money at work, and the manager must earn the hurdle on it before carry. A constitution that excludes the charge from the hurdle base has given the manager a hurdle on less than the register contributed, and the register reads the hurdle's base for the charge's inclusion.

The charge in the manager's own structure

The charge is received by the manager, which may be the regulated entity in the fund's jurisdiction or an affiliate of it, under the management agreement; the regulated entity may delegate to an adviser elsewhere and pay it a share. The register sees the charge leave the fund and does not see where it goes, and the management agreement's delegation and payment terms are the manager's own. A regime that requires the regulated manager to retain substance reads the delegation for how much of the charge leaves the jurisdiction, and a manager that pays most of its charge to an adviser abroad has a substance question the charge's routing raises.

Co-investment and the charge's incentive

A manager whose charge runs on the fund's invested capital has an incentive to hold positions in the fund rather than to offer them as co-investment, because co-investment carries a reduced charge or none. The allocation policy addresses the incentive by fixing the fund's share by its constitution and its limits rather than by the manager's charge, and the committee reads allocations for it. The charge's base is one of the conflicts the co-investment policy names.

The offset

The manager or its affiliates may receive income from the positions: board payments from portfolio companies, arrangement or monitoring payments, break payments on transactions that do not complete. The constitution says whether that income reduces the charge, in whole or in part, and the offset is a term the register reads as closely as the base, because a manager that keeps transaction income has a second charge the register did not negotiate. A full offset returns all such income to the fund by reducing the charge; a partial offset shares it; and a constitution silent on the offset leaves it with the manager.

Co-investment and parallel vehicles

The charge on a co-investment vehicle is the co-investment document's, and usually reduced; the charge on a parallel vehicle is the parallel's document's, and usually the same as the fund's. A manager that charges the fund on commitments and a parallel on commitments charges twice on the same programme, which is correct if the parallel is separately raised capital and a double count if the parallel is a reallocation of the fund's. The constitution and the parallel's document are drafted to the same programme, and the combined charge is what the register reads.

The lender's reading

A capital-call lender reads the charge for the drawdowns that fund it, because the charge is drawn from commitments, and for the step-down, because after it the charge is smaller and the drawdowns fewer. A lender to the manager reads the charge as its borrower's income, and the step-down as the date the income falls, and prices the facility to the fund's investment period. The manager's successor fund, whose charge replaces the first fund's at step-down, is the lender's refinancing.

The onshore vehicles' own charges

Onshore holding companies have their own running costs and may pay the manager's onshore affiliate a charge for managing them, under a service agreement in the jurisdiction. That charge is a cost of the onshore vehicle, reduces what reaches the fund, and is a charge the fund's register pays without seeing in the fund's waterfall. The constitution says whether onshore charges to affiliates are offset against the fund's charge or are disclosed as separate, and a register that reads only the fund's charge has read one of two.

By term · by effect	The register's reading	The manager's reading	What the administrator computes
Rate	The visible number	The negotiated number	The rate on the base
Base during the investment period	Total commitments	Total commitments	Commitments at each date
Step-down trigger	The earlier of date and event, with the successor-fund term	The date	The base from the trigger
Base after the step-down	Invested capital net of write-downs and realisations	Invested capital at cost	Cost of positions held, adjusted
Floor	A commitments charge in disguise, if high	The cost of running the fund	The greater of the two
Extension charge	Reduced, to incentivise sale	Continued, to fund the work	As the constitution says
Offset	Full	Partial or none	The income deducted
Onshore affiliate charges	Offset or disclosed	Separate	As the constitution says

A charge, as a type

A fund fixes a rate on total commitments during an investment period of a stated number of years from the final close, ending earlier on the successor fund's first close or on the fund being substantially invested; thereafter a lower rate on invested capital, defined as cost net of realisations and of permanent write-downs as the valuer determines, with no floor; a reduced fixed charge during any extension; a full offset of transaction income; and disclosure of onshore affiliate charges with an offset of half. The successor fund holds its first close in the fourth year; the step-down triggers; the base becomes invested capital. Two positions are written down in the sixth year and the base falls. The fund extends in the eleventh year on the reduced fixed charge and sells the last position in the twelfth. The register paid what the base and the step-down implied, and the manager's budget was met in every year but the last, as the constitution said it would be.

The structure paper's page

The structure paper carries a page on the charge: the budget, the base in each period, the trigger and its events, the invested capital definition with its adjustments, the floor and its reason, the extension charge, the offset, the treatment of onshore affiliate charges, and the computation over an illustrative life on two realisation paces. The page is written before the term sheet so that the term sheet carries the base beside the rate, and it is the page the anchor's counsel reads with the budget.

The disclosure the regime expects

Each regime expects the memorandum to state the charge's rate and base, the step-down and the offset, so that a prospective holder can compute the charge over an illustrative life. A memorandum that states the rate and refers to the constitution for the rest has stated the term the holder will compare and withheld the terms that decide the sum, and the regulator reads it as such at inspection. The memorandum carries the base and the step-down in the paragraph that carries the rate, and the constitution carries the clause.

The second fund's reading

A manager's second fund is read against the first fund's charge: whether the step-down held, whether the write-down reduction was applied, whether the offset was computed and returned, whether the extension charge was what the constitution said. A first fund whose administrator's computations the committee read without dispute is a record; one whose charge was disputed at the step-down is a record too. The second fund's anchor reads the first fund's constitution and its computations together, and the second fund's charge clause is the first fund's lesson.

Four cases, as types

A register negotiates the rate down by a fraction and accepts a constitution that runs the charge on commitments for the whole life. The fraction saved over ten years is less than the difference between commitments and invested capital in the fifth year alone.

A constitution steps the base down to invested capital at cost, with no reduction for write-downs. The fund's largest position is written to nothing in the seventh year and the manager is paid to hold it at its original cost for five more.

A constitution has no successor-fund trigger. The manager raises its next fund in the third year and is paid on commitments by both funds for the same people until the first fund's investment period ends by date.

A constitution fixes the base, the trigger, the write-down reduction, the extension charge and the offset, and the rate is negotiated last. The charge over the fund's life is what the register computed before it subscribed.

What each party holds

The manager holds its budget, the rate and the floor it needs to run the fund.

The register holds the base, the trigger, the write-down reduction and the offset.

Counsel holds the definition of invested capital and the step-down clause.

The administrator holds the computation of the base at each charge date.

The valuer holds the write-down determinations that reduce the base.

The committee holds the reading of each computation and the consent to extensions.

Where it surfaces

It surfaces at the term sheet, where the rate is and the base is not. It surfaces at the first drawdown for charges, when the administrator computes the base and the register sees the sum. It surfaces at the successor fund's first close, when the trigger fires or does not. It surfaces at the first write-down, when the valuer's determination reduces the base or the constitution says it does not. It surfaces at the first realisation at a loss, when the base falls by cost and the manager's income falls with it. It surfaces at the extension, when the manager's charge for the work of selling is read against its incentive to hold. And it surfaces at the manager's own budget, when the step-down leaves the manager with less than it needs to run the fund's last years.

The cost of getting it wrong

A register that accepted a commitments base for the whole life has paid for deployment work in years when no deployment happened. A register that accepted invested capital at cost without a write-down reduction has paid to hold positions that were gone. A register without a successor-fund trigger has paid for people another fund was also paying for. A manager without a floor on a fund that sold early has run the fund's last years at a loss, and a manager that runs at a loss sells what remains at whatever it can get. Each cost was in a clause, and the clause was read after the rate.

The manager's budget

A manager that presents its budget to the anchor has shown what the charge is for, and the anchor reads the budget against the charge on the proposed base over the proposed life. A budget that the commitments charge covers twice over is a charge set for profit; a budget the invested capital charge does not cover after the step-down is a step-down that will not hold. The budget is the register's evidence for the base and the floor, and a manager that will not show it has asked the register to accept a charge for costs it may not see.

A timeline, as a type

At the term sheet the base, the trigger, the definition and the offset are named beside the rate. At the first close the constitution carries them and the manager's budget is in the data room. In year two the administrator draws the charge quarterly in advance on commitments. In year four the successor fund holds its first close; the trigger fires; the base becomes invested capital at cost, net of realisations and permanent write-downs. In year five the valuer determines a permanent write-down and the base falls. In years six to nine realisations reduce the base by cost. In year eleven the fund extends on the reduced fixed charge, with the committee's consent, and the manager sells the last position in year twelve. The register's computation at subscription matched the administrator's computation over the life, within the write-down nobody could predict.

The committee's reading

The committee reads the administrator's base computation at each charge date: the commitments during the investment period, the trigger's status, the cost of each position held after it, the realisations and their dates, the valuer's write-down determinations and their application, and the offset's deductions. It reads the manager's request for an extension with the extension charge in view. And it reads the onshore affiliate charges disclosed under the constitution. A manager that sends the computation with its inputs has a committee that reads it in a sitting; a manager that sends the sum has a committee that asks for the inputs.

The sequence

1. The manager's budget is prepared and the charge over the fund's life is computed on the proposed base and step-down.
2. The base during the investment period, the trigger, the base afterwards and the floor are fixed.
3. Invested capital is defined, with write-downs and realisations, and the offset is fixed.
4. The extension charge and the onshore affiliate charges are fixed.
5. The rate is negotiated on the terms above.
6. The administrator computes the base at each charge date and the committee reads it.

Questions a manager asks

Is a floor usual. Common on smaller funds, where invested capital after sales would not cover costs; the register reads its level.

What counts as substantially invested. A stated proportion of commitments invested or committed to positions, with reserves for follow-ons; the constitution's definition.

Does the charge run on recycled capital. If the constitution permits recycling and the recycled amount is invested, it is in invested capital; the constitution says whether recycled amounts count toward commitments for the charge.

Can the charge be drawn in advance. Quarterly in advance is usual, with an adjustment at the next date for changes in the base.

Is the charge paid through the waterfall. No; it is drawn from commitments as an expense and is part of the contributed capital the hurdle runs on.

What about the charge on undrawn commitments after the step-down. None; the base is invested capital and undrawn commitments are outside it.

Terms used

Annual charge: the manager's periodic payment for running the fund, on a base at a rate.

Base: the amount the rate applies to, commitments or invested capital.

Step-down: the change of base, and possibly of rate, at the investment period's end.

Invested capital: the cost of positions held, as the constitution defines and adjusts it.

Successor-fund trigger: the end of the investment period on the next fund's first close.

Offset: the reduction of the charge by transaction income the manager receives.

What to read

The constitution's charge clause, the definition of invested capital, the investment period and its triggers, the extension provisions and the offset; the manager's budget; the administrator's base computation; the onshore service agreements. On this site, the economics and vehicles rooms under Structures.