I nvestors in private equity have enjoyed significantly more influence in recent years, leading buyout funds across the industry to concede lower fees and more favourable terms to secure fresh capital.
Post-crisis, investors have successfully negotiated lower management fees, zero transaction fees and greater co-investment rights, representing huge victories over an industry long criticised for its expensive and multi-layered charges.
But many investors want more. A survey of institutional investors published in September by Preqin found that 61% of respondents had rejected a fund based on its proposed terms and conditions. A further 10% said they frequently declined to invest in private equity funds with “unfavourable terms and conditions”.
Meanwhile, secondaries specialist Coller Capital’s June 2014 survey of global private equity investor opinion showed that 44% of investors thought the balance of power between investors and funds had reached equilibrium. However, about the same proportion of investors believed fund terms and conditions would continue to change in their favour.
The proportion of investors turning down funds is high but should be greater, says Mark Calnan, global head of private equity at consultancy Towers Watson. “In a sense you would expect everyone to have turned down a fund because of terms,” he says. “Private equity is one of the few industries where practically all the products are at the same price point, roughly 1.5% or 2% management fee and 20% carried interest.”
Overall, fees remain too high, says Calnan, leaving plenty of room for improvement.
In addition to the headline fees described by Calnan, a further spate of costs might include transaction fees – about 1% of the enterprise value of an acquisition (essentially abolished or significantly offset in many post-crisis funds) – and monitoring fees. Buyout firms nominally charge monitoring fees to portfolio companies for ongoing advisory services, traditionally priced from about 1.5% of the company’s EBITDA. In reality, the fund’s investors ultimately pay for monitoring fees.
While due diligence by investors should cover all aspects of a fund – including its team and performance record – terms and fees can swing a commitment decision.
“Almost all players I meet that manage pension capital focus on net returns and that is what we are here to deliver and that, of course, includes the cost side of the whole equation, as well as the expected return on the gross side,” says Karl Swartling, chief executive of Swedish pension fund AP6, which focuses on domestic and Nordic private equity.
Swartling says his team rarely turns down an investment based on one factor, describing due diligence and investment decision-making as a “holistic assessment”.
AP6 weighs up the benefits of a buyout firm’s network, niche and ability to source the best deals against the cost of investing.
Towers Watson directly compares the cost of investing in a private equity fund with that of investing in a vehicle in a different asset class altogether – a modus operandi Calnan expects to become more common among investors as categories for capital allocation become increasingly blurred.
The model uses a fund manager’s fee structure and assumptions about expected alpha to predict the proportion of the alpha left for the investor versus the proportion left for the fund manager. On these terms, a side-by-side comparison with other asset classes leaves private equity looking significantly less attractive.
“In most asset classes, approximately one third of the expected alpha is being kept by the manager via fees and carry,” says Calnan. “In private equity, our analysis usually results in 50-60% going to the manager.”
Such research highlights the growing pressure on private equity funds to make their costs more competitive with other asset classes.
“When a manager comes to you with a two-and-20 fee schedule and you have a private debt fund that, while not quite achieving the same expected returns, is not a million miles away and charges one-and-15, and charges that on invested rather than committed capital – despite a slight difference in gross expected return, you can understand why some investors are looking at the expected fee drag and favouring alternative strategies,” says Calnan. “That comparative view is only going to increase over time as asset class barriers are broken down.”
Cutting the fat
According to the Preqin survey, management fees, fees paid on committed but uncalled capital and carried-interest structures were the biggest issues for investors, with 54%, 39% and 28% of investors, respectively, believing alignment of interests could be improved in these areas.
But basing the cost of investing in a private equity fund on the headline fees alone is too simplistic and investors must assess the price of their commitments case by case. This means scrutinising ‘hidden’ charges, such as travel expenses and transaction-break fees – costs which Brian Schleimann Nordlund, an investment director at Danish pension fund administrator PKA, says should come under the management fee but which are often charged as additional fees.
Such costs are often blamed for significant drag on returns and highlight the continuing failure among much of the buyout industry to be transparent, even to its clients.
“I would rather we did away with more of these hidden expenses and moved to a world where costs were much more transparent,” says Schleimann Nordlund.
“The most important thing is to make sure the documentation is very clear on these things,” says Hans Holmen, a principal consultant at consultancy Aon Hewitt. “We do not like the concept of hidden fees and believe they should be paid by the management fees.”
Other areas for improvement highlighted by Preqin’s survey included the amount of capital committed by the fund manager to its own vehicle (cited by 24% of respondents), the hurdle rate (17%), the rebate of deal-related fees (13%) and non-financial clauses (9%).
Market participants stress that negotiating on fund terms is about fairness and providing the right incentive for management teams. Fighting for the cheapest possible deal could prove counter-intuitive.
“A blind cost-cutting attitude is wrong,” says Swartling. “It is in the interests of both parties to have a more open dialogue over what type of infrastructure is set up and the cost structure required to drive the business in a successful way. We do want the investment teams we invest in to make sure they have the access to the best industrial expertise.”
Neither can investors bargain hard across the market, says Holman. “If there is a high-quality start-up manager or a manager raising a very small fund, they really need a reasonable management fee stream to pay for all of those things,” he says.
There is still more movement needed and more investor pressure, insists Calnan.
“I often read these surveys about high proportions of investors that have turned down funds,” he says. “But when we try to talk to investors and get a sense of whether they are going to vote with their feet, if it is a hot fund we are often surprised and disappointed about the level of engagement investors are willing to have on fees.
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