Ann Tadajweski and Dennis Pereira Comment on Variations in Fee Structures and Recycled Proceeds in Private Credit Vs. Private Equity Funds

Private Equity Law Report has quoted Akin Gump investment management partners Ann Tadajweski and Dennis Pereira in the article “Forming Private Credit Funds: How Material Variations in Fee Structures and Recycled Proceeds Compare to PE Funds (Part Two of Two).” The article highlights some of the key differences in how management fees and carried interest for private credit funds are structured compared to private equity. It also describes the growing importance of recycling provisions in negotiations with LPs.

According to Tadajweski, management fees for all but a handful of private credit sub-classes often begin at 1.5 percent and can be discounted from there. Some private credit funds, the article says, charge a portion of management fees on committed capital during the investment period, while others only receive the fee on invested amounts.

In some limited instances, the article says, a manager can negotiate a PE-like blended approach where management fees are charged on both committed and invested capital. A manager will often agree to a smaller number on the unfunded portion, with stratification based on the size and timing of the commitment, said Tadajweski.

There is not, however, an industrywide approach to how fees on committed capital are structured. “For example, I would say the fee rate for more retail-like investors (i.e., smaller high net worth investors) is often the same on unfunded amounts as for funded amounts. Thus, it would effectively replicate them just charging one committed amount,” observed Tadajweski. “In addition, I’ve seen more substantial size-based discounts on the fee rate on unfunded capital as an easier giveaway by managers expecting to invest the funds quickly.”

With carried interest, Pereira said the rate often ranges from 10-15 percent, which is attributable to the comparatively limited volatility of the underlying assets of private credit funds. “You are targeting, in some of these strategies, high single-digit or low double-digit returns, so the carried interest rate tends to be reduced accordingly,” he noted.

With that said, though, Pereira added that the carried interest rate can be closer to 17.5-20 percent for more aggressive assets with return profiles similar to PE assets, such as special situations and distressed debt.

Another material difference between PE and private credit, the article says, is reflected in the waterfall distributions typical of each asset class. Tadajweski pointed out that PE funds typically have an American waterfall (i.e., deal-by-deal carry) that enables GPs to collect carried interest after returning contributed capital to LPs that is specifically attributable to the realized investment. Conversely, she said, it is far more common for a private credit fund to use a European waterfall that requires all contributed capital to be returned to investors before the GP earns carried interest through the preferred return.

The article then looks at differences between PE and private credit with regard to recycling proceeds. The first, it says, relates to the duration of a fund’s reinvestment period relative to its investment period and whether recycling is even permitted, as is often not the case with PE funds. “In PE, if you hit an early home run, the idea is that you would distribute those proceeds to LPs,” observed Tadajweski.

Where PE funds permit recycling, the length of time permitted can be similar to that for private credit funds. There is a marked difference, however, in that amount of time relative to the duration of each asset classes’ respective investment periods. Pereira explained the issue using a hypothetical involving private credit and PE funds with three- and six-year investment periods, respectively. “The reinvestment period for the private credit fund isn’t reduced from 24 months to 12 months just because its investment period is shorter. It remains at 24 months.”

The second difference is the frequency with which recycling occurs in each asset class. “Credit funds that expect a lot of recycling during the investment period have, in some instances, very limited drawdown periods – for example, only one year – to call capital from investors to invest,” noted Tadajweski. “But, once that capital is drawn, they can often reinvest the proceeds for an additional two years,” which incentivizes managers “to put capital to work very quickly.”

There are some exceptions where the two asset classes are more closely aligned, the article reports. As an example, the recycling provisions of private credit funds sometimes mirror those of PE funds based on investors’ preferences. “Some products are put in place with an expectation that investments will throw off significant interest income to be regularly distributed to LPs,” Tadajweski said.