Monitoring fee

A monitoring fee flows from the operating company to the sponsor's management company, in return for board participation, strategic input and governance. Transaction fees on acquisitions and refinancings usually sit alongside it. It is entirely distinct from the fee the sponsor charges the fund's investors, and confusing the two is the single most common error on this topic.

The modelling consequence is straightforward and frequently missed. This is a real cash cost of the business. It belongs in free cash flow as an operating expense, not below the line because the recipient happens to be an affiliate. Omitting it overstates cash available for debt service, overstates debt capacity and understates true leverage.

Lenders are alert to it. Credit agreements typically carve out a permitted amount inside the restricted payments basket, cap it, and require it to be subordinated to debt service or suspended entirely in a default or above a leverage threshold. That is an incurrence covenant doing exactly what incurrence covenants are for.

It is contentious because the sponsor sits on both sides: it controls the board that approves the fee and it receives the fee, while a higher fee reduces the cash available to repay debt and build equity value. Investor pressure has pushed hard on this, and the usual answer is an offset, crediting some or all of the fees received against the fee investors pay at fund level. How much is offset is a negotiated fund term, and it has moved a long way in investors' favour over time.