Private Equity: A two-speed market
Moves to standardise private equity reporting raise challenges for limited partners, Emma Cusworth finds
At a glance
• Pressure for standardised private equity fee reporting has grown.
• The Institutional Limited Partners Association has developed a template but adoption by general partners has been limited.
• Demand for private equity means successful general partners may continue to resist standardised reporting.
• Limited partners should co-ordinate better among themselves to ensure general partners adhere to best practice.
Private equity firms have come under pressure in recent years to increase transparency around their fees and costs. While it appears that change is happening, helped by the introduction of new templates to standardise reporting on fees, there is still some way to go. There is also a danger that the industry bifurcates when it comes to fee transparency, with some of the best performers continuing to dictate what they will disclose.
In 2014, a speech by the US Securities and Exchange Commission (SEC) director, Andrew Bowden, drew closer scrutiny to the lack of transparency around private equity fees and costs, particularly how expenses were allocated to funds.
“That was the first time someone had articulated so explicitly and so publicly several of the issues around transparency that many LPs were aware of or addressing privately,” says Jennifer Choi, managing director for industry affairs at the Institutional Limited Partners Association (ILPA).
Since then, transparency appears to have improved markedly. According to Iain Leigh, managing director for global private equity at APG Asset Management: “Until quite recently, there was a lack of consistency in reporting of fees and expenses by general partners (GPs). As a result of the global financial crisis and the increase in the number of GPs who became registered and subject to SEC review, there has been a significant improvement in the level of disclosure to the limited partners (LPs).”
Yet, despite these changes, issues remain and more transparency is needed. Yodia Lo, senior analyst for alternatives at the Church Commissioners for England, says: “There is still room for improvement, especially around expenses.
Many such costs should be included under the management fee, but they are tacked on as an extra cost instead. It is very difficult to negotiate, however, if you don’t know what is coming down the pipe.”
Ernst & Young’s 2016 Global Private Equity Fund and Investor Survey revealed that expense allocations are a key area of dissatisfaction. More than 40% of investors said they were unhappy with the information they received in a number of areas, including consultancy fees and broken deals.
Lo reports finding GPs “not particularly forthcoming” in this regard. “On the positive side expenses are capped, but the cap is still too high,” she added.
Cambridge Associates senior director for private investments research, Nicolas Schellenberg, believes that when LPs do crack down on one areas of fees, GPs get “creative somewhere else”, such as charging costs as expenses that may previously have been covered under the management fee. “It’s not always clear why or what has been charged to the fund,” he says. “This is an area that needs a lot more transparency.
“It would be interesting to understand the cost structure, or indeed the full P&L, of the fund management company, as the fees are meant to cover the cost,” Schellenberg adds. “If a fund manager asks for high fees, the question is: ‘why [and] what for?’.
“On the other expenses charged, the level of voluntary transparency could be better, but in our due diligence process we require each fund manager to lay those out, so we get the information in the end. Not all LPs are doing that to the same level though.”
In addition to the review carried out by the SEC, programmes aimed at providing a system to standardise the data provided on fees and costs, such as the Fee Transparency Initiative by the ILPA, have begun to make headway.
Initiatives such as the Invest Europe Professional Standards Handbook and Investor Reporting Guidelines are also contributing to expectations of greater transparency.
Leigh says: “The ILPA template was created to provide a consistent level of disclosure across GPs so that investors have a full understanding of the total fee load. The ILPA template has provided a framework to GPs outlining what the more sophisticated investors expect to see in the way of disclosure. Today we see the industry moving towards producing broader information on fees and expenses as, for example, more and more GPs adopt the ILPA template as best practice.”
The ILPA template, which has a clear process for calculating and attributing expenses and carried interest, for example, is considered by many to be the most credible model. “We believe that it will solve the issue around transparency and allow for a more consistent comparison between different managers,” Leigh says.
Standardising the data provided across the industry through the widespread adoption of a template would enable LPs to have a much clearer understanding of their total fee load and how that compares between funds, while GPs would also be able to streamline their reporting efforts. Given the considerable burden client reporting can present to GPs, adding greater efficiency to this process should be appealing.
As a member of the ILPA template project, Choi says her team had reviewed roughly 30 different fee-reporting templates being used by different LPs. “GPs are often asked to provide more information across a multitude of formats, which takes a lot of time and resources to complete. Over the long term, significant economies of scale can be achieved by rolling out a template such as ours to all GPs. Costs should therefore come down as template adoption increases.”
Bifurcation on transparency
However, there is a fear that the industry will bifurcate as funds with strong performance are able to resist the pressure from LPs for greater transparency and continue to dictate terms.
Sunaina Sinha, founder and managing partner at the placement agency and secondaries advisory firm, Cebile Capital, refers to a “two-speed market”. She says: “When LPs are trying to get into the most popular funds, they do not have the same negotiating leverage,” she says. As a consequence, where GPs’ funds are oversubscribed, LPs tend to drop their demands in areas like fee transparency.
As of November 2016, only nine GPs had endorsed the ILPA initiative. “That is a drop in the bucket,” Sinha says. Of the top 40 consistently top performing buyout fund managers in
Preqin’s Q1 2016 private equity performance update released in November, not one had endorsed the initiative.
With private equity in demand, a meaningful change in the level of fee transparency provided by top performing funds will be more difficult to achieve. The level of dry powder waiting to be put to work by private equity firms is already at a record high of $839bn (€794bn), up $21bn in the third quarter of 2016.
However, if LPs worked closely together to push for improvements in fee transparency from private equity firms, the chances of arriving at an industry standard that even top performers felt compelled to follow would be greatly improved.
“What is important is that more LPs speak to each other and co-ordinate better,” Schellenberg says. He sees benefits for LPs in signing up to an initiative such as the ILPA template.
“Take those terms to negotiations with GPs and make them explain why their standards are different if they are,” he says. “Be more aware, negotiate and work together. GPs too often play LPs off against each other. If LPs spoke to each other more that would be very helpful as it would increase the pressure on GPs to improve transparency.”
Of course, when it comes to the funds that are hardest to access, there is a certain degree of prisoner’s dilemma inherent in co-operation in case that means they do not get the access they want and need, especially in a period of prolonged low returns.
In conjunction with LPs’ efforts, associations like the ILPA also need to broaden their membership, targeting different geographies and a wider range of investor types. Doing so would ensure GPs face pressure to adopt the standards ensuring they become best practice. This becomes more challenging as the number of competing standards increases, which should also prompt more co-ordination between those association and technology providers to arrive at a common standard.
“Investors tend to be happy with the level of transparency around fees if they are happy with the level those fees are at,” Schellenberg says regarding management fees.
“If they think the fees are too high, they want more transparency.”
UK NEST’s comprehensive view on costs to improve outcomes
• NEST Corporation
• UK defined contribution master trust
• Location: London
• Assets: £1.3bn (€1.5bn)
• Annual management charge/TER: 0.3%
• Contribution charge: 1.8%
• Transaction costs: range from zero to 0.098% (higher-risk fund)
Members of NEST’s defined contribution scheme are reliant on the master trust to provide a significant proportion of their retirement income. This makes managing costs a priority to ensure long-term returns are not eroded.
But risk management is equally important, so NEST has focused on building a diversified portfolio from inception. While it favours low-cost passive solutions for most equity investments, for other assets it recognises that active management is a better option.
Mark Fawcett, CEO of NEST, says: “It’s impossible to invest passively in certain assets, like direct property holdings.” This asset class comes with a number of additional costs. Property involves legal, survey and valuation fees plus stamp duty. “These costs don’t alter our rationale for including property to grow our members’ pots over the long term and we can do so within our budgets,” says Fawcett.
For other asset classes it is worth choosing an active manager rather than taking the passive route. For example, active management adds value to credit investment through better risk control, he adds. “For this asset class, choosing an active manager is less about improving returns and more about avoiding significant defaults by managing the credit risk,” says Fawcett.
NEST does not disclose the fees it pays to either its passive or active managers. Nor does it reveal details about how fees are structured. But it does, however, work to negotiate the best possible fee for each mandate – which its scale enables it to achieve.
By taking this approach of managing risks through diversification and using a limited budget wisely to spend where active management can add real value, it is possible for a fund to operate under a cost constraint and deliver stable performance.
Fawcett says: “According to a recent report by Defaqto, not only are NEST’s returns in the top quartile but they also have the top three and five-year Sortino ratio, which measures the downside volatility of a fund.” In other words, the fund should achieve its aim of protecting its members from excessive volatility.
There are costs, other than investment management fees, associated with running a defined contribution (DC) scheme. The UK government has increased its focus on transaction costs with the introduction of the Occupational Pension Schemes (Charges and Governance) Regulations in 2015.
Fawcett says: “Transaction costs are another drag on performance so it’s vital to understand how they are being managed.” These costs will be higher for active rather than passive strategies.
While the default fund’s blend of passive and active managers helps to keep a lid on transaction costs, it is possible to further control these costs by using specific investment mandates.
Fawcett says: “Transaction costs on actively managed credit strategies can be reduced by employing a buy-and-hold strategy.” And NEST’s use of target-date funds can further lower transaction costs. Fawcett says: “This enables us to trade assets between funds rather than selling in the open market.”
While there has been a close focus on investment and transaction costs, administrative fees can also be a significant cost for a DC scheme. A proper procurement process is vital to find the right administrator.
Fawcett says: “It’s important to ensure the provider’s system is robust enough to cope with high levels of demand.” A system that fails frequently will cost more.
Fund managers also have administrative costs. Fawcett says: “That’s why we look at a manager’s total expense ratio rather than the annual management charge.” TER costs are often higher at smaller asset managers because they lack scale.
All of the costs associated with running a DC scheme have the ability to erode returns – that is why none of these costs should be ignored. Fawcett says: “The governance committee needs to look at the all-in costs of running the fund to ensure they are transparent and correctly managed.”