Until relatively recently, the 2 per cent management fee, 20 per cent carried-interest and 8 per cent hurdle felt like a standard in private equity, with little prospect of change.
“By-and-large the fee scale has remained unchanged for some time,” says Geoff Singleton, senior investment consultant with Hymans Robertson, where fees account for just 10 per cent in product-selection scoring systems. “We would typically advise clients that they shouldn’t get too hung-up on one manager being more expensive than the other.”
But there is significant variation between products and strategies, and some charges are more sensitive to negotiation than others, so there is scope for shopping around.
Venture capital is the most expensive strategy: here, the average is 2 per cent, with some of the best weighing in at 2.5 or even 3 per cent. Mezzanine funds tend to be cheaper.
Within buyout, 2 per cent was more standardised before the advent of mega-funds. In fact, 2 per cent still holds below the $1bn (€745m) level, 1.75 per cent is the standard between $1bn and $4bn, and above that management fees can be as low as 1 per cent.
“When private equity firms started they were raising £25m (€37m) and a 2 per cent management fee didn’t amount to very much,” says Sam Robinson, a director with SVG Advisers responsible for funds of funds. “Nobody got rich on it – in fact, people generally took a pay cut from an investment bank to work in private equity.”
With $10bn funds now being raised, 2 per cent looks much more compelling for the general partner (GP) – and painful for the limited partner (LP).
“The bit that people ignore is that teams have got bigger with the funds,” says David Currie, chief executive at Standard Life Investments (Private Equity) Ltd. “Leading European managers who had a team of 10 a decade ago today employ 70 investment guys and a battalion in the back office. You’re not going to get highly-qualified people to work for buns, and some middle-range managers are actually not making much money out of their management fee.
“The reason we invest through funds is that it’s cheaper for us than setting up that infrastructure. And as an investor, one concern we have is, given the size of the team and the fund, is it going to be viable? Can the fund pay its rent? Is it big enough to attract deals?”
Nevertheless, private equity is quite scaleable. “The amount of time and money spent on trains and planes looking for small deals is going to be pretty much the same when you’re looking for large deals,” as Mr Robinson puts it. A ten-fold increase in assets under management generally requires around a four-fold expansion of costs – and that’s an opening for investors.
Charging on commitment
“We have seen limited partners pushing hard to get managers to drop fees when they raise bigger funds,” says senior investment consultant Jane Welsh of Watson Wyatt, “and there does seem to be movement.”
The fact that management fees are almost always charged on commitment, rather than on cash drawn down, also causes some consternation. In effect the client pays two per cent to manage its own money.
“You don’t want to force the manager to invest in any old rubbish just to start earning a fee, but it’s still a pretty significant thing for clients to get over initially,” says Ms Welsh.
Managers point to an increasing trend to have fees “step-up” to the full levy during the first few years and “tail-down” as cash is returned after the investment period, restoring a level commensurate with the cash invested over the fund’s life. Tail-downs can be anything from 10 per cent per annum to 50 per cent one-off.
Those charges are sometimes based on the (decreasing) value invested rather than the commitment; furthermore, some funds charge on the commitment minus the costs of realised investments while others take off the costs of unrealised investments, which represents better value. Write-downs might also be taken into account.
“There is quite a lot of variation in the detail,” says Ms Welsh. “It’s important to really understand what’s going on.”
Management fees cause most concern. Generally investors like to see managers motivated by a bit of carry.
Twenty per cent is overwhelmingly the standard, especially for buyout funds, although the best venture capital can be more expensive at 25-30 per cent.
The good news is the pretty generous hurdle rate, usually 7-8 per cent – with Mr Singleton citing at least one manager offering 10 per cent.
Originally the hurdle provided investors with a risk-free benchmark similar to gilt yields, so at the dawn of the industry in the 1980s it was sometimes as high as 12 per cent.
Nowadays, 8 per cent ties in more with actuarial assumptions for public-equity returns.
“There have been attempts to align the hurdle with the FTSE All-Share or equivalent,” recalls Mr Currie, “but that never took off. Investors didn’t like it because it was too complicated.”
Even the hurdle comes with a sting in the tail – namely the “catch-up” clause. With this in place, managers don’t just take 20 per cent of profits in excess of the hurdle. Instead, once the hurdle is reached, they take more than 20 per cent until they have regained the 80/20 share with the client across the fund’s entire profits. That “hurdle” is really a “trigger.”
“Some managers will take 100 per cent until they regain the 80/20 split,” says Ms Welsh. “Others will phase it in, perhaps taking 60 per cent. I think that makes sense and that the on/off switch is unhelpful.”
Investors also need to know what measures are in place should later performance tail off after early investments pushed returns over the hurdle. Is there an escrow account, or do clients have to rely on the manager to hand over the carry he wants to claw back?
At fund-of-funds level the management charge is typically between 65 basis points and 1 per cent.
US providers are less likely to charge carry on underlying primaries, but UK and European players generally charge 5 per cent. Secondaries come in at 5-10 per cent, co-investments at 15-20 per cent.
That means wide variations across portfolios - another opening for shopping around which also throws up alignment-of-interest concerns for investors.
“It’s a legitimate question,” says Mr Robinson. “I’ve heard investors say they want a fund to be purely primary or secondary or co-investment, because they don’t want their manager to be motivated to put money into co-investment and not primaries, because he’s getting carry.”
A fund’s ultimate strategy allocation may not be clear at the point of fundraising.
“With an Asian fund, for example, we will say that 70-100 per cent will be primaries, 0-30 per cent secondaries and 0-30 per cent directs,” explains Cyrill Wipfli, head of investor relations at Partners Group. “On our normal primaries we charge 90-100 basis points management fee and zero performance fee; on secondaries we charge 125 basis points and 10 per cent; on the direct side we charge 1.5 and 15. It can be difficult to compare funds of funds with one another: you have to make assumptions and come up with a blended rate.”
Consultants generally provide various client-commitment, returns and cash-flow scenarios to which managers can apply their fee structures.
“These models are important because the fund-of-funds level fee is a significant drag on performance,” says Watson’s Ms Welsh.
It doesn’t stop there. With distributors included, investors can find themselves paying a 10 per cent front-end fee, one per cent to the distributor, one per cent to the fund of funds and two per cent to underlying managers.
And although headline fees remain stable there is a trend for extras such as transaction, monitoring and search fees, amounting to as much as 50 basis points. These are compounded by the directors’ fees that managers can actually earn.
Room to manoeuvre
“Some managers offset these fees, but not all of them – and there is often room to manoeuvre on those things,” Ms Welsh advises.
As Mr Wipfli argues, with an industry re-up ratio approaching 70 per cent it is short-sighted to hide fees in your first fund if you want clients to invest in the next one.
“We call it the ‘mother test’ here at Partners Group,” he says. “Every Monday we price our different products in the executive board and we always ask ourselves, ‘Would we sell that product to our mothers?’”
Right now it would not be a hard sell. The latest Thomson Financial’s US Private Equity Performance Index shows an annual return to September 2006 of 19 per cent, net of fees, across all strategies. Buyout funds in the $250m-$500m range came in with 37.2 per cent net. A significant period of underperformance may be necessary to correct the current supply-and-demand imbalance.
“There are going to be times when fundraising is much harder and investors are going to be in a much stronger position,” says Ms Welsh.
On the other hand, the managers who are most sensitive to that possibility are those who have survived long enough to remember the last drought.
According to research cited by Mr Wipfli, in the European buyout sector top quartile performance is 17 per cent per annum while the bottom quartile is flat, and the thoroughbreds tend to win races year after year to a much greater extent than in other asset classes.
Given a normal (Gauss) distribution of 100 hedge-fund managers, after year two only five of the first year’s top quartile are still in that top quartile, and by the third year only one survives. Testing the hypothesis with the TASS hedge-fund database revealed that the theoretical statistical line is “pretty close to the real line.”
“Similar analysis in private equity found that the more experienced fund managers had better performance,” he says. “They’d built a firm capable of building proprietary deal-flow, with the most professional investment managers and due diligence. The likelihood of the Roman XI fund outperforming the industry like the Roman X fund did is really there. That means everybody wants to invest in these experienced firms.”
So although one should not expect the best managers to start feeling too much pressure on fees any time soon, those same managers are acutely aware of the value of long-term investor relations – meaning costs are likely to remain stable.
