Given the nature of debt returns, investors should interrogate the de facto Management Fee structure to ensure there is an alignment of interests with the Fund Manager. While low headline Management Fees are alluring, investors should review the Information Memorandum to determine the actual costs they face and any impact to their risk-reward proposition.
Consider a hypothetical Fund Manager with a Management Fee of 0.5% p.a. Close review of the Information Memorandum may find disclosures that the Fund Manager may also be entitled upfront establishment fees. The impact of this entitlement is illustrated below.
The Fund Manager finds a borrower who agrees to accept financing of a 1-year loan at a 12.0% cost of debt.
The Fund Manager structures the loan as follows:
- 2.0% establishment fee paid upfront; and
- 10.0% interest rate – reflecting a 12.0% APR.
In this scenario, investors receive a net return of only 9.5% comprising:
- 10.0% gross interest earned; less
- 0.5% Management Fee
The Fund Manager earns a de facto 2.5% Management Fee comprising:
- 2.0% establishment fee; and
- 0.5% Management Fee
This raises several issues, the most obvious being the Fund Manager earning an de facto fee in excess of the disclosed headline Management Fee. Less apparent but more significant is the impact on the risk-reward proposition for investors.
While the loan is priced at 12.0% to reflect underlying borrower risk, the investor has only a right to a 10.0% interest income stream. In essence a lower rate of return than what is fair for that level of risk.
The author’s advice to prospective investors is to read documents in full, ask questions, and seek professional advice.