The remedy for a fee error is the money back with interest, allocated to the investors who paid; each of the four choices behind the figure can be challenged.
Recompute every fee period on the correct basis, take the difference for each period, carry each one forward with interest from the date it was paid to the date it is refunded, and allocate the total to the investors who actually paid the fee. On an illustrative fee base that kept a 24 million written-off investment for ten quarters, the overcharge is 882,000 and the refund at 5 per cent is 968,741, of which 86,741 is interest.
Worked in full in The Private Fund Compliance Officer by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Fee calculation errors are among the most common findings in private fund examinations, and the remedy is almost always the same: pay the money back, with interest, and document how the figure was reached. The compliance officer usually owns that calculation, or at least has to defend it. The arithmetic is not difficult, but each of its four choices (the corrected basis, the interest convention, the dates and the allocation) can be challenged, and each moves the number.
| Input | Value |
|---|---|
| Commitments | 300,000,000 |
| GP commitment, which pays no management fee | 6,000,000 |
| Fee-paying commitments | 294,000,000 (98%) |
| Management fee, on invested capital, paid quarterly in advance | 1.50% a year |
| Investment written off, left in the fee base in error | 24,000,000 |
| Quarters overcharged | 10 |
| Refund paid | 3.0 years after the first overcharge |
| Interest rate, compounded quarterly | 5.0% a year |
The LPA says invested capital excludes investments written off, so the 24 million should have left the fee base the quarter after the write-off. The error came to light in an annual fee test and was quantified the following quarter.
Overcharge per quarter = written-off cost × fee-paying share × fee rate ÷ 4 = 24,000,000 × 98% × 1.50% ÷ 4 = 88,200
Refund for each quarter = overcharge × (1 + rate ÷ 4)quarters from payment to refund
Investor's refund = total refund × its fee-paying commitment ÷ all fee-paying commitments
In Excel, with each overcharge in column B and the number of quarters to the refund date in column C: =B2*(1+$F$1/4)^C2, summed down the column. Use the actual payment dates and =B2*(1+$F$1)^((refund_date-pay_date)/365) if the fee was not paid on quarter dates.
| Quarter paid | Quarters to refund | Overcharge | Interest |
|---|---|---|---|
| 1 | 12 | 88,200 | 14,179 |
| 2 | 11 | 88,200 | 12,915 |
| 3 | 10 | 88,200 | 11,666 |
| 4 | 9 | 88,200 | 10,433 |
| 5 | 8 | 88,200 | 9,216 |
| 6 | 7 | 88,200 | 8,013 |
| 7 | 6 | 88,200 | 6,825 |
| 8 | 5 | 88,200 | 5,652 |
| 9 | 4 | 88,200 | 4,493 |
| 10 | 3 | 88,200 | 3,349 |
| Total | 882,000 | 86,741 |
The fund's fee-paying investors are owed 968,741: 882,000 of fees they should not have paid and 86,741 of interest, 9.8 per cent on top of the principal. An investor with 15,000,000 committed holds 5.10 per cent of the fee-paying commitments and receives 49,426, of which 45,000 is fee and 4,426 is interest. The GP commitment receives nothing, because it paid nothing.
The interest rate is a policy choice unless an agreement, an LPA clause or a regulator fixes it. Write the rate and the compounding convention into the remediation policy before the first error is found, so that the figure is not negotiated case by case. A rate chosen after the amount is known looks like a choice made to reduce it.
| Refund paid after the first overcharge | 0% | 3% | 5% | 7% |
|---|---|---|---|---|
| 2.5 years, as soon as the error stops | 882,000 | 919,214 | 944,969 | 971,509 |
| 3.0 years | 882,000 | 933,053 | 968,741 | 1,005,810 |
| 4.0 years | 882,000 | 961,362 | 1,018,094 | 1,078,086 |
| 5.0 years | 882,000 | 990,528 | 1,069,961 | 1,155,556 |
Each further year of delay at 5 per cent adds 49,353, then 51,867. The error ran 352,800 a year, so the cheapest part of the remedy is finding it early: an annual fee test that catches the write-off in its first year limits the principal to four quarters, and the interest with it. That is the business case for testing the fee base at every change in invested capital, not only once a year.
A fee refund is the overcharge for each period, compounded from its payment date to the refund date and allocated to the investors who paid: 968,741 here, 86,741 of it interest. Fix the rate and the method in policy, and test the fee base when it changes. How large a sample a fee and expense test needs is worked in how many expense allocations you have to test, and the free workbook for this case puts figures on the fee and expense questions the book covers.
Whatever the LPA, a settlement or the firm's written remediation policy specifies; absent those, a documented, consistently applied rate. It matters: on the illustrative 882,000 overcharge refunded three years after the first error, 3 per cent gives a refund of 933,053, 5 per cent 968,741 and 7 per cent 1,005,810.
Not if it paid no management fee. Allocate the refund in proportion to the fees each investor actually paid. Spreading the illustrative 968,741 over all 300,000,000 of commitments would pay the GP commitment 19,375 and short a 15,000,000 investor by 989.
It understates the refund if each period is not dated. Simple interest at 5 per cent on the 882,000 total for the average 7.5 quarters outstanding gives 82,688, against 86,741 computed quarter by quarter with compounding: a shortfall that always falls in the firm's favour.
This article is one calculation from The Private Fund Compliance Officer. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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