Fund chargebacks and expense allocations are a major component of any investment firm. This process includes the payment of expenses by the management company on behalf of the funds and the subsequent reimbursement of these expenses.  The specific terms of the fund chargeback process are dictated by the LP Agreement (“LPA”). 

A high-level process flow for the receiving of expenses and the process of invoicing funds for the reimbursement of these expenses looks like this:

Once the management company receives an AP invoice from a vendor or an employee T&E expense, it is up to them to understand how that invoice should be allocated between the management company itself and the underlying funds. This process can be as easy as sending the full invoice amount to a specific fund or as complex as using invested capital or another metric to calculate distributions across multiple funds. To add a layer of complexity, the fund structure often contains many entities that require their share of the expense. In addition, invoices may be received many months after the service is rendered, and the expense may need to be allocated using historical capital amounts or other statistics.  Each firm is unique in how these allocations must be distributed and processed. This often requires bespoke workarounds and solutions.

In addition, some agreements allow for charging employee salary expenses or 1099 contractor expenses that may be paid through a payroll provider.  This provides an additional challenge when producing the proper metrics to be used for any fund charge.

Regulatory / Audit Concerns:

Since these charges are billed to the funds and the funds are comprised of investors, the Securities and Exchange Commission (“SEC”) takes an active interest in ensuring the investors are being treated fairly and will often audit funds to ensure any expense allocations made are based on reasonable and consistent metrics.  It might not be okay to distribute the expenses evenly if one fund is much larger and a disproportionate amount of the charge should occur.  During audits, the SEC will require documentation of the statistics used to drive the allocation, and it will be incumbent upon the management company to provide this information and have it stored and ready for presentation.  If this information cannot be supplied to the satisfaction of the SEC, it could lead to fines of up to $1M or more. 

Top Pain Points:

Since the process seems straightforward, this task is often underestimated.  Below are some of the top pain points when trying to determine the amount of funds owed by funds:

• Allocations are not known at the time of the payment – there are certain expenses where the allocation is not known at the time the payment is made. This can include market data expenses or hardware charges where usage is determined in the future.  Allocations for these expenses must be made later, or a true-up might be necessary to account for the actual charges incurred by each underlying fund.
• Dependency on other systems or departments – Obtaining the current invested capital amounts or current market value might not be readily available. Funds might rely on this information from other systems or third-party administrators.  Some funds use prior month or quarter data to circumvent this issue.
• Capturing time spent – Some funds choose to allocate the costs associated with software development or other projects being worked on at the request of a specific fund or group of funds. Other firms may allocate payroll costs from shared services groups like IT and Operations.  To do this accurately, it may be necessary to document the time spent from these resources on these projects or tasks and then allocate them to the appropriate funds.  The process of capturing time and using the actual costs like salary or contractor rate can be difficult to implement.
• Expenses are capped – Some LPAs are written so that there is a maximum amount that can be charged to the funds. If expenses exceed that amount, they are absorbed by the management company.  Keeping track of these caps can be tricky.
• Pre-funding the management company – Depending on the amount of the fund expense, the management company may not have enough cash on hand to pay the vendors. In these cases, it is often necessary to ask the fund to transfer capital to the management company in advance of the payment. 
• Workflow approval – Many times, legal and compliance needs to be involved in the decision determining if a charge is billable to a fund. This often requires a sophisticated process flow to be built in the expense and AP systems or an ugly manual process.
• Providing invoices with details – Once the management company is ready to ask the fund for reimbursements, an electronic or physical invoice may be required. The invoice itself is likely not enough as funds would like to see the specifics of what they are reimbursing.  This can require the management company to list the specific invoices/services that they are passing on to the fund.  This exercise is often manual and time-consuming.

With growth comes complexity:

When funds are small and starting out, it is easy to keep track of these expenses using a spreadsheet or other offline method.  As firms start increasing in size and additional funds are raised, this manual method becomes more difficult, and the operational risk associated with this task is increased. 

The process of charging funds is often managed by a single person, and as the workload increases, it becomes hard to manage.

Solutions

There are several solutions that vary in complexity and elegance:

Option 1 – Through the Firm’s general ledger (“GL”)

One method we use is the GL system itself. Although some GLs may be better equipped to handle these allocations than others, each system may utilize some form of built-in allocation breakout.  Sophisticated systems allow the fund to convert the allocated expenses to accounts receivable invoices.  The benefit of this option is that it allows you to handle everything in a single system. Everything is in a centralized location and easy to manipulate or change when needed. In addition, if done properly, the management company can get a clear picture of the type of expense that was incurred before the reimbursement invoice is sent to the fund.  This allows for clear vendor reporting and easier budgeting and forecasting.  The downside to this option is that many GL systems don’t have a perfect solution to each unique firm’s needs, and often, the system may need to be tweaked or customized.

Option 2 – Third Party Solutions

The other method we have recently seen grow in popularity is using a third-party solution to create and send out the fund chargebacks. This is a huge advantage, especially when utilized in conjunction with less robust GL applications. Instead of having to create robust allocation rules in a system, this solution allows the client to simply create one allocation rule to send to the third party for them to then breakout downstream. The downside to this solution is connecting another system to any existing systems the firm uses, as well as adding another step in an already complicated process.

Option 3 – Manual / Excel

Many funds handle these allocations in Excel.  This can work when the fund is small or if the allocation itself is not complex.  Once multi-level allocations and a variety of statistics are used in the allocation process, this can become untenable.  In addition, this method is error-prone and more likely to result in audit points and fines.

Conclusion 

​Fund chargebacks are often scrutinized and can be very complicated.  There are several solutions varying in cost and complexity.  FinServ Consulting has worked with a variety of investment firms and have helped design many elegant solutions to account for these complexities and can create an approach that meets your firm’s needs.