Almost since its inception, the private equity industry has suffered a poor profile in the press, with its members often portrayed as asset strippers, locusts and fat cats.

This view holds largely as a result of the belief that private equity fund managers as a whole are focused on personal gain at the expense of both companies and workers.

But the banking crisis and subsequent recession have exposed those private equity houses that were swept along by the hubris of financial engineering, and have paved the way for a new model in the industry.

The standard private equity model was formed some 28 years ago, when the average fund size was about £20m, and was heralded as an alternative asset class capable of producing a level of return to match the associated investment risk.

Indeed, the average 10-year annual rate of return (IRR) in private equity stands at 13.1 per cent, compared with just 1.6 per cent for the FTSE all-share index.

This track record has succeeded in attracting more capital into the industry.

The standard private equity fund structure is a 10-year closed-end fund with a 2 per cent management fee and 20 per cent profit share, which is commonly known as carried interest. This structure naturally attracts more capital to the more successful private equity fund managers. But in spite of the apparent success of private equity as an asset class, the structure itself is open to abuse, and has enabled a large number of fund managers to become very wealthy on the back of management fees alone. This has removed the drive and incentive to achieving the sole objective of all institutional investors: making significant capital gains.

However, the current lack of liquidity in the industry, caused by reduced allocation to the asset class and the lack of realisation at the levels of recent years, has encouraged pension funds and others that invest in private equity to seek a closer alignment of interests.

Private equity fund structures must therefore go back to basics if they are to remain attractive to investors.

A management fee should cover only sensible costs associated with running a private equity house, while the real reward should lie in carried interest, which is directly related to the success of the investment. It is also important that investors are not irreversibly tied into a poor-performing private equity fund and have the ability to leave without penalty.

This level of flexibility and investor-friendliness can be found in a number of models already.

By aligning the interests of manager and pension fund in this way, private equity fund structures focus on capital appreciation and can provide the basis for transparent reporting.

A pension fund also has the ability to remove poor- performing managers and cease their commitments without incurring the severe penalties that are currently associated with a standard private equity fund structure.

However, unless the pension fund industry is prepared to act in unison, wholesale change to the current private equity structure will remain difficult.

At present, those pension funds that act alone risk being “sent to Coventry” by the most popular and better-performing private equity fund managers.

But while some power has returned to pension funds since the global recession began, the ability to effect real change to private equity fund structures remains restricted unless the industry begins to act as one.

The lingering private equity fund structure and remuneration policy are products of an outdated industry with its roots in 1982. The model encourages managers to raise larger and larger funds, which has left an “equity gap” for businesses at the smaller end of the market.

However, the current lack of liquidity in the fundraising market has provided the pension funds with a unique opportunity to insist on changes in fund structure and remuneration policy and align their interests with the next generation of private equity fund managers.

Mike Fell is a partner at independent private equity firm, Key Capital Partners

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