Private equity managers are turning a deaf ear to a clamour for lower fees from investors who are increasingly concerned about the impact of high costs on long-term returns.
More than two-thirds of private equity managers believe midsized investors will never have the clout to reduce the industry’s traditional charging structure: a fixed 2 per cent management fee and a 20 per cent performance fee.
“Large investors that are prepared to commit a significant chunk of money can secure lower management fees, but smaller players simply don’t have that kind of leverage,” says David Lanchner, a spokesperson for Palico, the private equity fund marketplace that conducted the research.
The confidence among private equity managers that they can withstand pressure from investors to cut fees stands in marked contrast to developments elsewhere in the investment industry.
Many hedge fund managers have been forced to reduce their charges in response to investor dissatisfaction with high fees and poor performance. Low-cost index-tracking funds are attracting rising inflows, while the cheapest actively managed mutual funds are taking market share from competitors with higher fees.
Christian Kvorning, investment director in the alternative investment arm of PKA, the €31.5bn Danish pension fund manager, says private equity managers have been “turning the screws” on investors.
“It is striking how incredibly sticky ‘two and 20’ has proved as a pricing model. Even after the financial crisis, contract terms showed little improvement and have worsened in recent years because fundraising has been so easy for private equity managers,” says Mr Kvorning.
He adds that management fees — which are only supposed to cover a fund’s running costs — are sufficient to make private equity managers “very rich” if their funds become sufficiently large.
But Graham Elton, head of the European private equity practice for Bain, the consultancy, questions the research. He says that “very few funds achieve two and 20 any more”.
“The best funds are significantly oversubscribed and have been able to exert pricing power. Poorer performers have had to accept some reduction in fees to secure their fundraising,” he says.
The available data on fees are mixed. A survey published in May by King & Wood Mallesons, the London-based law firm, suggests management fees charged by private equity firms have remained virtually unchanged since 2008.
However, a survey published in July by Preqin, the data provider, indicates there has been a modest fall in annual management fees for European buyout funds, from an average of 1.99 per cent in 2010 to 1.78 per cent for funds raising money this year.
Some of the fall may be due to the popularity of larger buyout funds with assets of at least $2bn, as these tend to have lower management fees.
There are around 1,774 private equity funds currently seeking to raise a combined total of $455.4bn, so competition for investors’ cash is fierce.
Christopher Elvin, head of private equity products at Preqin, believes the balance of power is shifting as private equity managers “are having to work harder to attract capital” from investors.
Nonetheless, just over a tenth of the investors surveyed by Preqin cited management fees as their biggest point of contention, ahead of concerns about performance fees and how these incentives are calculated.
Mark Calnan, global head of private equity at Willis Towers Watson, the world’s largest adviser to institutional investors, says management fees are “slightly lower” than they were before the crisis but “not as much” as investors might have hoped.
He adds that private equity managers are in a strong bargaining position so it is essential for investors to focus on fee negotiations before making a commitment, particularly given the more muted outlook for returns from other asset classes.
Willis Towers Watson invests between $1bn and $2bn annually into private equity on behalf of its clients. Some clients have been able to achieve reductions in management fees (of around 30 basis points on average on the headline charge) through negotiations.
“Investors have to be prepared to vote with their feet if the contract terms are not suitable. But that can be difficult for some very large asset owners that have significant capital to deploy when they are looking to reinvest with particular managers where they enjoyed success in the past,” says Mr Calnan.
Some investors have chosen to join forces in an effort to secure better terms. The Orange County Employees Retirement System, known as Ocers, created a platform in 2014 to help smaller US public pension funds to combine their private equity investments in an attempt to lower costs.
Such initiatives, however, are relatively infrequent, even though more than half of the investors surveyed by Palico said combining forces could lead to lower fees and better returns. In contrast, almost two-thirds of private equity managers dismiss alliances among investors as a tactic to reduce fees.
“It is clearly in the interests of private equity managers to nip any hopes in the bud that they might be flexible on fees,” says Mr Calnan.
But the buyout industry may soon be forced to reduce fees more dramatically, or face the risk of clients taking their private equity investments into their own hands.
A number of large investors, including PGGM, the Dutch pension scheme, have built sizeable in-house private equity teams, rather than relying on costly external managers.
Co-investments have also become a popular way for investors to avoid paying high management and performance fees. In these arrangements, investors commit capital alongside the private equity manager into a company, rather than investing in a fund.
USS Investment Management, the £49bn UK universities pension scheme, has invested in private equity since 2007. Last year, USS sold holdings of $940m in 13 private equity funds to Ardian, the French asset manager, in favour of making private equity investments through an internal portfolio management team.
Geoffrey Geiger, head of private equity at USS, says: “We are very focused on value for money. We wanted to achieve greater control over costs, better governance of the assets and higher returns by deciding ourselves when would be the best time to sell on our investments.”
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