💸 The hidden fees in angel and secondary investing

Vieje back here again. I just realized that I fell for a deepfake video last night…I saw a short video of a bunch of celebrities and entrepreneurs condemning Kanye and thought, “wow, that’s crazy that they got all these famous people together to film this video so fast”. It appears no one’s safe, and it might be time for me (everyone?) to delete social media.

On another note, I was intrigued by this Bloomberg article about hedge funds and their passthrough investment fees (paywall). The article discusses the fees and expenses that large hedge funds charge their Limited Partners or LPs for short. In one example, the author writes:

“In 2023, the main hedge fund at billionaire Dmitry Balyasny’s eponymous firm notched a gross return of 15.2%.

Investors walked away with a gain of just 2.8%.”

That’s a lot of gains going to fees and expenses. I am not a LP in any hedge funds, but if I was, I wouldn’t be very happy to be giving up the vast majority of my returns to fees.

Unfortunately, these “hidden” fees are not just exclusive to hedge funds. They happen in our world of investing in startups as well. Today, I wanted to take the time to discuss the costs of some of our angel or secondary investments in startups.

But first, let’s go back to the article.

🤔 What are passthrough fees?

When someone invests in a hedge fund, they usually become a Limited Partner (LP) in the partnership. The General Partner (GP) is the investment manager in charge of managing the entire partnership’s investments, and when the partnership makes money, the GP distributes cash to all the LPs and themselves.

Gains aren’t the only thing distributed to the LPs though. Losses, fees, and expenses also pass through to the LPs. The most common fee is a management fee which gets charged to the LPs every quarter. This is a standard practice in the private investment fund world and a lot of GPs take 2% of each LPs account every year as a management fee. Investment funds do have costs to cover such as administrative, salaries, research, etc. so the management fees help cover those annual costs.

In addition to management fees, performance fees called carried interest are also standard.

While investors are expecting to pay the annual management and performance fees, the Bloomberg article explores something else:

“That parceling out of costs is one of the most coveted perks of running a multistrategy hedge fund. Investors are so eager to pony up money that they effectively write a blank check, agreeing to cover just about any expense managers deem reasonable, in good times and bad.

The term for that: Passthrough fees.”

Unfortunately, detailed receipts of these expenses are not public knowledge, but it ranges from boring items such as compliance costs to lavish entertainment expenses. In the case of many hedge funds, LPs are giving up a lot of their returns to these expenses.

🔍 Are there passthrough fees in my angel or secondary investments?

This is a newsletter with a focus on personal finance for startup folks, not hedge fund investing so of course there’s a startup angle here.

Some of you may have explored or dabbled in angel investing or investing in startup equity through the secondary markets. Platforms such as AngelList have made it easy to invest in startups. Quite often, a GP or a sponsor will get access to an investment round or an opportunity to buy shares of a company, and then offer that opportunity to investors like you and I. AngelList is a great platform that makes things easy and handles most of the hard work for the sponsor and the investor.

I’m a big fan of AngelList and other platforms like it. I read through nearly every opportunity that comes across my inbox, and I’ve invested in a handful of them. That said, it’s very important to be careful and understand exactly what you are buying. While fees are normal, you should watch out for hidden or disguised fees, especially in the fine print.

Let’s first talk about what’s standard.

It’s fairly normal for funds or special purpose vehicles (SPVs) to charge investors a management fee which is an annual fee or an upfront one-time fee. These GPs and sponsors need to be compensated for their time and efforts for organizing the opportunity. In addition, most opportunities will charge a carried interest which is a performance based fee if the investment does well.

Funds or SPVs also may charge expenses. For example, there is an annual audit and tax preparation, and platforms such as AngelList may charge the fund as well. Most of the opportunities I see will give a flat % cap of the investment to set aside for fees. For example, if it’s a 10% cap on fees and I invest $10,000 - then the fund may charge up to $1,000 in fees and I may be returned only $9,000 after that charge.

Compensating the GP or sponsor, and paying expenses is not uncommon for a private company investment and has even become standard practice. However, you’ll need to determine what is an appropriate fee for their work.

⚠️ So what should I look out for?

When opportunities charge a combination of management fees, upfront fees, and/or expenses, it can get a bit more hairy. I’d say it would be weird and unusual for a fund or SPV to charge all three, but I have seen it happen. Most platforms, such as AngelList, do a great job in being transparent about these fees, but sometimes you have to dig through the fine print to figure out what your actual costs are.

Fee structures can also introduce complexity. Complex doesn’t always mean bad - certain circumstances may warrant an unusual fee structure, but of course, there are always bad actors out there that purposely hide stuff in the fine print.

An accelerated management fee is one structure I’m seeing more and more often. We discussed above that it is fairly normal to pay a GP about 2% of your investment annually. But it would be unique to see a GP accelerate those fees to the first year to pay the GP today rather than over the course of the investment.

Lastly, perhaps the most insidious of the “hidden” of the fees I’ve seen is a markup on the purchase price of shares. First, it’s important to distinguish the hidden markup versus a traditional broker fee in the secondary world. It’s normal for brokers and platforms to charge a percentage of the purchase price to the buyer and/or seller. For example, a seller may be quoted a bid for $100 but the broker or platform may charge 5% or $5 per share, so the seller gets $95. That’s perfectly normal and happens often in the secondary markets to compensate the broker for their efforts.

However, I’ve unfortunately seen many opportunities in my inbox with a built-in mark-up in price which is often done on purpose to hide another built-in fee from the investor. For example, a GP or sponsor is putting together an SPV to buy shares in XYZ company at $110. In reality, that GP or sponsor is actually buying the shares for $100, and then pocketing that $10 in fees. Most people won’t know this is happening unless they read the fine print of the offering.

Let me highlight one opportunity that hit my inbox recently. As much as I want to name and shame, I’ll keep things diplomatic and round prices to keep confidentiality up.

A sponsor was offering an opportunity to invest in an SPV which would buy shares of a very hot company in the AI space. They were charging a 20% carried interest, which is pretty typical. Here’s where things got crazy, there was a 10% upfront fee and they also reserved the right to charge up to $13,000 per investment for expenses which are both above standard. Last, but not least, they charged a 5% mark-up on the purchase price. I only knew about this mark-up as I was aware of the actual funding round price from my job, but most wouldn’t have known about this without reading the fine print in the long legal documents.

So to summarize, there was effectively a 15% upfront fee, 20% carried interest, and up to $13k in expenses. If I invested $100k, my investment’s principal balance may have only been $72k after all the fees and that’s prior to paying carried interest. Insane.

It’s important to really understand what you’re buying, especially if you don’t do this for a living. These hot opportunities may seem attractive on the surface but might be less so once you dig into the details.

As always, we’re here for you if you have any questions. Until next time!

Things we’re digging:

• Things you don’t see too often. AppDynamics Founder Jyoti Bansal sold the company to Cisco and then started two new startups. He’s now merging those two startups together.
• Every 4 years, no matter who is in the White House, we hear about carried interest. Will President Trump actually get rid of carried interest with all the VCs in his inner circle?