Rise and rise of private equity fees
By numerous measures - its assets under management, its proportion of M&A activity, the number of people it employs, its ‘market share' of media attention, and its contribution to many pension funds' returns - the private equity industry has enjoyed explosive growth in western Europe and the US in recent years. The disciplines of the private equity ‘model' (emphasising a sharpening of corporate strategies, a slimming-down of unnecessary activities and expenditures, and an acceleration of action in implementing change) have time and again produced exceptional performance at portfolio companies controlled by private equity funds. When ready to realise value on these investments, private equity funds (and their backers, mostly institutional investors) have often reaped handsome, benchmark-beating profits.
For many pension funds, which as a class of investors provide about half the financial fuel firing the private equity industry, the industry's evolution and profitability is very good news. Faced with worrying funding gaps, in particular, pension funds can find private equity's potential outperformance provides a means to narrow the mismatch between longer-term assets and liabilities.
Also, if their willingness to devote an
increasing share of their assets to private equity is any guide, then large volumes of
pension funds around the globe must be gaining comfort with placing more and more companies in private hands. Perhaps, in doing so, they are relieved that these companies' regulatory burdens are less onerous than those of public market peers, in post-Enron times.
Pension funds may also be encouraged that privately-held companies can often force change more rapidly, and invest more readily for the long-term, than can public ones in the full glare of wider constituencies with an arguably more myopic outlook. Such interested observers can range from trade unions with political influence, to research analysts tracking day-to-day stock prices.
Yet, in one important respect, the private equity industry's rise in stature may not be entirely welcomed by pension funds, and their trustees and staffs. Trustees and staffs have formal, fiduciary responsibilities to beneficiaries that require them to manage assets prudently. Such prudence should involve ensuring that pension funds receive ‘value for money' in engaging professional managers and specialist advisers, like the General Partners (GP) of private equity funds, to pursue interesting and potentially rewarding investment strategies on their behalf.
Speaking more practically, these individuals also have exposure, in a less formal, more political sense, should their beneficiaries object to the way their savings and investments are managed, or to the manner in which those hired to manage their money are paid. More specifically, as compensation issues always attract extra attention, trustees and staffs are vulnerable to criticism if they are seen to be rewarding their advisers excessively, at levels perceived to be disproportionate to services rendered or profits earned.
These features of trustee and staff life can be particularly present and sensitive at the public sector pension funds, like the immense ‘state funds' in the US representing the employees of the California or New York state governments, for example, or local authority ones in the UK. Their processes are more transparent than those of private sector pension funds, as board decisions, manager selections and performance data are required to be disclosed publicly.
Also, their boards and committees reviewing and approving investment proposals often include representatives of beneficiaries. Such representation brings often modestly paid firemen and teachers into face-to-face contact with wealthy ‘Masters of the Universe' from the financial world. In the process, the economic distinctions between them can stand out starkly, as the financiers seek management fees to run their firms that are fortunes relative to the beneficiaries' likely net worths, much less salaries.
As the volume of capital devoted to the private equity industry as a whole has risen dramatically, much of it derived from pension fund sources, so has the size of funds under management by individual private equity firms exploded. Ten years ago, the largest single private equity fund run by a European GP was on the order of €750m. In its day, this was considered a ‘mega-fund'. In today's market, just at the point when that 1996 fund's 10-year life is drawing to a close, a €750m fund is seen as solidly ‘middle market' in size. The term ‘mega-fund' does not begin to apply now before capitalisation crests above €5-7bn. In the more mature and larger US private equity market, both the historic and contemporary comparables for ‘mega funds' need to be inflated by at least 50%.
During this time, however, perhaps surprisingly, as fund sizes have risen so dramatically, typically the size of the team managing those funds has not expanded to the same degree. While fund sizes may have risen five-fold over the last 10 years at an established firm, very often the size of the team may only have doubled.
To some degree, there is nothing wrong with this disparity. Well-honed, senior experience probably counts for more in making good investment judgments than does a raft of junior staff devoted to investigating a proposition. Also, the markets have continually produced ever larger targets suitable for private equity investing, allowing absorption of substantially increased pools of fund capital without sacrificing returns.
Yet, at the same time, contrary perhaps to economic theory, in the main the financial terms and conditions governing funds have hardly evolved at all over the last 10 years. Management fees, in percentage terms, have dropped to a small degree as fund sizes have risen hugely, but their headline numbers remain stubbornly above at least 1% (often still 1.5%) of fund capital, per annum, even on multi-billion funds. This means that individual GPhips, which on a €750m fund (with a then 1.5-2.0% annual fee) a decade ago would have received about €12-15m in management fees each year to run their firms, today can receive on the order of €60-90m per year in such fees on their latest €5-7bn fund, a five- or six-fold increase.
In the meantime, undoubtedly firm overheads have increased more rapidly than a doubling in team size might imply, as top talent has become more expensive, and due diligence more costly, now that private equity firms tackle larger and
more complex assets, against tighter timescales. Yet, even allowing for this extra inflation in running costs, it seems clear that the combination of massive fund size increases, relatively fixed fee rates, and often quite restrained growth in team sizes has led to extraordinary operating leverage for the management companies (ie, GP vehicles) of many private equity funds, as businesses in their own right.
Twenty or 25 years ago, in the infancy of the industry, newly-established private equity firms set management fees of about 2% on their first, quite small funds, a level that allowed these firms to run on a ‘cost-plus' basis.
The more compelling gains to the GP would be generated by deal profits from which investors also benefited. Now, management fee flows are so huge that investors worry that GP are insulated from real
downside, and less motivated to achieve the kind of upside that attracted these investors to private equity in the first place.
The private equity industry could counter these statements by reminding critics of its economic structures that management fees are effectively a loan to the GP - such fees must ultimately be repaid to investors out of investment proceeds, before the GP receives its profit stake. It might also suggest that, notwithstanding these fees (often very large in absolute, annual amounts), the net, after-costs returns to investors on most private equity funds over the long-term have remained sufficiently high to compel further institutional investment in successor funds.
In economic theory terms, it could also point out that the there is an inelastic supply of high quality, top performing private equity firms which, when met with an expanding supply of capital interested in their services, helps explain why the best firms feel little pressure to adjust their terms. (Weaker or lesser-performing firms get the benefit of these largely fixed fee rates - a puzzle in economic theory terms, as one would expect them to have less pricing leverage.)
This anomaly likely arises because of the passivity of many institutional investors, which choose not to fight these battles individually, nor to organise themselves into consortia that might make a GP feel their combined weight in forcing reductions in rates).
Finally, the industry might claim that no single firm can ‘break out of the pack' by reducing its fees, as it would harm its competitive position by having lesser resources with which to pay for its teams and deal evaluations - and certainly no investor wants to see talent leaving, nor corners cut on due diligence, at a firm it backs.
These may be valid counter-arguments in isolation, but they may not take proper heed of the wider stage on which, given its growth, the private equity industry now operates. As the amount of assets the industry manages increases (as does those assets' proportion of the total investment ‘pie'), so will the attention of regulators become more intense.
As the scale of companies that the industry controls expands, so will political interest in its impact on employment as well as economic growth. As the industry generates more and more wealth for its participants, not just from management company profits but also from investment gains, so may the tax authorities become more focused on their fair share, or even a higher, ‘windfall' cut.
Finally, as the industry's true profitability becomes more widely-recognised, major sources of its capital, like pension funds, may find it harder to justify to their beneficiaries a continuation of financial support. Should this happen, pension fund trustees and staff may not necessarily be acting absolutely rationally in a financial sense (assuming the private equity industry continues to perform), but they may have little choice but to respond to the pressures of internal or external politics, and to powerful rhetoric objecting to unfair, ‘fat cat' rewards.
As part of its maturation, besides basking in the glow of its success, increased role in economic life, and ever-larger funds under management, perhaps the private equity industry should take stock of itself by other measures. Just as private equity owners frequently function as ‘company doctors' in healing and strengthening the corporate assets they control (often asking tough questions and making difficult decisions along the way), perhaps the industry should examine itself in the same dispassionate, even uncompromising light. Its focus on opportunities (correct, given that the industry is founded on growth and revitalisation as principles) could be matched by an assessment of threats (realistic, given its prominence and the tenor of the times).
A perhaps overdue realignment of general and limited partner interests, focused on areas of contention like fees, might be orchestrated collectively in an industry-wide forum, so that no one firm gained nor suffered disproportionately. That said, realistically, highly motivated economic animals like the managers of private equity funds - especially top-performing ones, who could charge ‘premium' rates, given amount of demand for their supply - are unlikely to agree to coordinated action simply to improve the industry's image, or to pre-empt a political challenge.
Yet, given the ever higher regulatory and political stakes it will likely face, perhaps the private equity industry should not immediately return to business as usual. Surely at least a good, intellectually honest debate could be held among industry leaders - involving both managers of funds and their investors - about the state of alignment of their individual and collective interests. In particular, they could assess whether circa-1980 partnership structures and compensation systems, once relevant for a nascent industry, remain so for a far larger, mainstream one a generation later.
Out of such a debate might come an impetus to design new structures fairer to all parties, an awareness of investors' willingness to back fresh concepts, and a confidence among managers of funds that they could break out of the pack in offering unconventional, more flexible terms. In the process of assessing itself and deciding on ameliorative actions, important industry constituencies - like pension funds - might be well-served, and the industry's long-term health and direction might remain within its own control.
John Barber is a managing director of Helix Associates in London. The views expressed above are personal