This is the sixth article in an ongoing series on managed funds – part one: using the Sharpe ratio to assess fund performance;Â part two: identifying appropriate benchmarks for private equity funds;Â part three: evaluating common measures of private equity performance;Â part four: understanding the negative impacts of pension fund complexity; and part five:Â revealing the perverse incentives of pension fund managers.
“It’s not what you pay a man, but what he costs you that counts.” – Will Rogers
Here is a statement about the private equity industry that virtually no one would dispute: fund managers make an absolute killing through fees.
It is easy to see why. Most can still get the two-and-twenty deal by which the fund collects 2% of invested capital annually as a management fee, in addition to keeping 20% of profits from investments. Even funds that cannot claim quite so rarefied a fee structure still make out like bandits; even those funds with limited track records or unproven managers rarely get less than a 1.5% management fee and 12.5% of profits – a real “bargain” in the mega-fee world of private equity. Yet major allocators to private equity, such as pension funds and family offices, have started to balk at the fees they pay, especially when the sector’s performance may not be all it has been vaunted to be (see part two and part three of this series for more details on private equity funds’ – arguably – lackluster performance).
Influential allocators have employed a number of strategies in an effort to reduce onerous fees. One of the most popular methods of fee reduction is to demand co-investment. A co-investment is essentially a side deal whereby the allocator invests money directly into a target asset (let us say a small company) in addition to the money invested through the fund itself.
A quick primer on co-investment
The rationale for co-investment is it gives the allocator the same level of gross return on investment, but with reduced fees; since the co-invested capital will not be subject to management or performance fees, net-of-fees return will be expanded significantly.
Imagine Pension Fund A, which allocates capital to Private Equity (PE) Fund B. For the sake of simple arithmetic, let us assume the following:
- Pension Fund A allocates $50 million to PE Fund B.
- Pension Fund A’s allocation represents 25% of PE Fund B’s assets under management (so PE Fund B has a total of $200 million under management).
- PE Fund B uses a traditional two-and-twenty fee structure (so once all capital is deployed, Pension Fund A will be paying $2 million a year in management fees alone, plus 20% of profits).
- All asset purchases by PE Fund B will be done with cash (i.e., there is no leverage).
- There are no other transaction fees, taxes, etc. on the capital invested or returns thereon.
With those assumptions in mind, we can explore a simple example: PE Fund B moves to buy Company C for an all-in purchase price of $20 million. Pension Fund A’s allocation makes up a quarter of PE Fund B, so it will effectively be contributing $5 million to the purchase. After the acquisition is made, PE Fund B works its magic on Company C, streamlining processes, cutting costs, expanding production, etc. so that five years later it can sell the company for $60 million – a $40 million profit, with a cash-on-cash multiple of three times.
So the share of gross profits going to Pension Fund A is $10 million, which amounts to an annualized rate of return of about 24.5%. Not a bad haul – until we start factoring in fees. Remember, Pension Fund A has been paying annual management fees worth 2% of invested capital, which totals $500,000 for the five-year life of the investment, or 10% of the value of Pension Fund A’s investment in Company C. Then comes the performance fee: 20% of the $40 million profit is $8 million. Netting out all fees, Pension Fund A now has $7.5 million in profit on a $5 million investment (annualized rate of return: 20%), with a quarter of gross profits flowing to PE Fund B.
Now let us take the same example, but this time Pension Fund A has a co-investment agreement with PE Fund B. In this case, PE Fund B will pay for 80% of Company C and Pension Fund A will buy the remaining 20% directly. Thus, Pension Fund B will pay $16 million ($4 million of which is Pension Fund A’s capital) and Pension Fund A will pay $4 million. In this case, Pension Fund A has effectively doubled up its investment, but half is not affected by fees. Instead of $7.5 million in profit, Pension Fund A profits $8.75 million. That is the power of co-investment, in theory at least.
The problem is private equity funds have found ways to get their fees by other means, whether a principal is investing through it or as a co-investor.
Theory collides with reality
Despite its popularity, the real-world benefits of co-investment to principals is muddier than it might first appear. Indeed, co-investing has, historically speaking, produced relatively poor returns to principals. That deficient performance can be attributed, at least in part, to the fact co-investing tends to escalate in frequency during industry booms when acquisition prices are particularly high. Principals seek to access deal flow directly as they see larger and larger sums passing to the private equity fund managers, but do not necessarily consider the possibility such large-ticket sales are the product of asset price inflation. Hence, allocators that seek co-investment opportunities may find themselves exposed to losses thanks to buying in at asset price highs.
More significantly, private equity funds can simply shift how they charge fees to capture more of the value of an investment asset. When dealing with a portfolio company, for example, a private equity fund can charge the company management fees of its own; the fund controls the company and its working capital after all. These fees can be difficult to identify, but can be quite significant. There are cases in which funds have charged their portfolio companies fixed management fees, as well as fee structures that involve a percentage of invested capital. Other funds have squeezed out fees through contracts stipulating they will charge portfolio companies when they are sold off. Such sale fees are usually low, perhaps 1% of the value of the sale, but that is no insignificant amount when dealing with large assets – and when added to any management fees charged to portfolio companies on an ongoing basis. A percent or two really adds up when compounded over time.
In the case of co-investments, these downstream management and sale fees may not be reimbursed. Thus, co-investors may be paying significant fees and not even know it, or at least have only limited knowledge of their scope. In fact, a co-investment fee structure might even see a larger percentage of income flow to the private equity fund than under a standard fund arrangement (though that would be an extreme case).
Clearly, the headline fee structure advertised by a private equity fund may not look much like the fees being paid in practice. In fact, there can be an incentive to pass fees downstream through management or service agreements because they are more difficult for allocators to identify, compute and understand. This incentive is magnified in scenarios where allocators are trying to limit their fees through such strategies as co-investment.
Returning to our simplified example, Pension Fund A allocated to PE Fund B, which charged no additional fees to portfolio asset Company C. Pension Fund A sees the two-and-twenty structure and can calculate its costs and has the potential to mitigate some of them through a co-investment scheme.
Now consider this alternative scenario: Pension Fund A allocates to PE Fund B*, which has all the same headline terms except for a lower management fee: this second fund charges half the rate, or 1%. Pension Fund B* buys Company C* (which we will assume is identical to Company C) and Pension Fund A co-invests for a quarter of the value of the acquisition. This seems like a great deal to Pension Fund A’s managers; they are getting the same deal as they did with their allocation to PE Fund B, but this time have only half the annual management fee. However, what Pension Fund A does not fully comprehend is that PE Fund B* has entered a management agreement with Company C*, the terms of which stipulate PE Fund B* will receive an annual management fee worth 1% of invested capital, as well as 1% of the company’s sale price upon exit as an additional consideration.
Assuming the purchase and eventual sale of Company C* happens on the same terms as Company C, those service fees and exit consideration would total $1.6 million (in addition to its headline one-and-twenty fee structure). That means Pension Fund A is paying more, albeit indirectly, to PE Fund B* than it does to PE Fund B, despite the former’s headline management fee being ostensibly lower.
Beware what lurks beneath the surface
Allocators looking to reduce their fees have to do more than ask for co-investment opportunities. They have to demand a more radical transparency from private equity funds that takes into account all fees, both direct and indirect. Until there is sufficient will – and knowledge – in the allocator community to turn transparency into a norm, private equity funds will continue to find ways to squeeze out as much as they can.
Allocators need to be aware of the methods private equity funds can use to mask or distort their fee structures. Knowing how these funds operate means they can ask the right questions. Information is king in an industry notorious for its opacity.
