Do your maths carefully
Over the last 10 years, our firm, together with other investment consultants, have led a crusade against opaque charging structures (commonly known as ‘dirty fees’) for quoted portfolios. I am pleased to say that the battle has largely been won as far as UK-based pension funds are concerned, although there is a long way yet to go on the continent. Gone are the transaction-based charges, the additional charges for ‘overseas’ assets, and the separate scales for assets invested in in-house pooled funds. UK pension funds can now easily work out how much they are paying their fund managers.
Not so the world of private equity ! Even the most experienced investor will find it impossible to understand how much their venture capitalist manager is charging without building a spreadsheet model. But charges are not just opaque, they are also very high. In fact venture capital investment can cost 30 times more than quoted investment management. This means that a pension fund with a 3% weighting in venture capital could be paying almost as much for the management of those assets as the rest of the portfolio combined.
It is absolutely imperative, therefore, that investors evaluate private equity returns net of all fees and costs. In order to do this you need to understand what these cost items are, and in many cases, make assumptions in order to calculate how much income they will give the venture capitalist.
The whole question of fees is complicated because venture capitalists are remunerated both directly from their clients as well as from third parties in the form of commissions and fees. They sometimes claim that only the former should count as a ‘cost’ to the investor, since third party commissions do not come out of the investor’s pocket. We would argue that the various third party commissions are only earned because of the deal that is being undertaken, and therefore they belong to the owners of the assets that are backing the transaction. Commissions and fees that are paid by third parties could be handed back to investors, and to the extent that they are retained by the venture capitalist, they are lowering the return that investors could have earned.
When working on behalf of our clients, we use a simple calculation to show the overall costs of private equity investment - the difference between the return on the underlying assets and the return that investors have actually received.
First, most private equity partnerships charge set-up costs to the partnership. These include items such as the legal costs of drafting the partnership agreement, and it is true that in other assets categories these sorts of costs would normally be borne by investors. However, investors should satisfy themselves that they are not unknowingly subsidising the venture capitalist’s marketing and fund raising expenses. Set-up costs are clearly a ‘one-off’ for each partnership, and they are usually subject to a maximum.
Investors in other assets will be familiar with the concept of an annual management charge. These charges exist in private equity as well, but be careful, there are two things to watch out for. At between 1.25% and 2.5% per annum, they tend to be far higher than the sorts of annual charges investors may be used to paying. But more importantly, the headline figures can be misleading, for the annual management charge usually applies to the committed funds, rather than the invested funds. In other words, if an investor commits to provide £10m to a fund, he will be charged an annual management fee based on the full £10m from day one, even though it may take three to five years to actually draw down the funds.
This is justified by venture capitalists on the grounds that their workload involves finding and completing deals, and that is most time consuming in the early years, while the funds are still being drawn down. However the average amount of funds invested over the full life of a partnership is typically half the size of the commitment, because it takes three to five years to fully invest the funds, by which time the earlier investments will be coming to fruition. What this means for investors is that a 2.5% per annum management charge is really a 5% per annum charge on assets invested.
To further complicate matters, once the investment period is over (typically the first five years of a 10 year partnership’s life), the annual management charge may reduce to take account of investments that have been realised.
The other direct fee paid by investors is the performance related bonus, usually called the ‘carried interest’. It makes a lot of sense to align the financial interests of the venture capitalist with those of the investor, particularly as this is an asset class (unlike some others) where perspiration counts. Carried interest arrangements can be quite complex. There is usually a minimum ‘hurdle’ rate of return that the partnership has to deliver to investors before the venture capitalist can get his carry. Once the hurdle has been surpassed, many venture capitalists demand a ‘catch-up’, which means that they receive their performance bonus on the profits that have already been distributed to investors as part of the hurdle. After the catch-up, venture capitalists take their carry on all further profits.
Investors need to take a very close look at the fine print in the performance bonus clause. Some venture capitalists determine the carry on an investment-by-investment basis. Rather sneaky, as the nature of the beast is such that there will be some investments that fail, producing a -100% return. Other investments can produce returns in excess of 100% per annum. A combination of stars and dogs could leave the overall return of the portfolio at, say, 25% per annum. However, if the performance fees are calculated on an investment-by-investment basis, then the profitable investments could trigger performance fees with no offset from the loss making investments.
There are a number of other cost items that investors should watch out for. Venture capitalists may receive transactions commissions, syndication fees, director’s fees, underwriting fees and monitoring fees in the course of investing your assets. If they do, they will be significant, and investors should know how much they are and who is getting them. If they are going to the venture capitalist, then that is a further source of remuneration, and it will reduce the return that could have been earned by investors.
Private equity is a more expensive business than other classes of investment, mainly because there is a lot of due diligence and expense involved in evaluating potential deals, many of which will be aborted. Investors should therefore expect to pay more for the management of this asset class, and they should only invest if they feel confident that returns net of fees and costs will still be sufficiently above quoted alternatives to make it worthwhile. However, the lack of transparency of costs and fee structures is very unhelpful, and pressure should be put on the venture capitalists to move towards a cleaner basis.
Kerrin Rosenberg is with consultants, Bacon & Woodrow in London