Are Private Equity Fees Too High?
Management fees charged by private equity firms to LPs continue to come under fire. Most recently, Warren Buffet, Malcolm Gladwell, Calpers, and even Congress have been questioning whether the industry standard 2% management fee and 20% carried interest is reasonable. But we’re learning that reasonable can be a subjective term.
A recent article in the Wall Street Journal stated, “Calpers Is Sick of Paying Too Much for Private Equity.” The article went on to show that 85% of the $25.7 billion invested in private equity is charged the industry standard 2% management fee along with 20% carried interest. Although the 12.3% Calpers earned over the past 20-years on private equity investments outperformed their other alternative allocations, they estimate overall performance would have been 19.3% without fees and costs.
While Calpers is crying foul, the Yale University endowment, led by David Swensen, is on the flipside of the equation. Yale has recently defended the fees they pay private equity managers, saying, “What Buffet, Gladwell and other fee bashers miss is that the important metric is net returns, not gross fees.” The endowment goes on to say, “Performance-based compensation earned by external, active investment managers is a direct consequence of investment outperformance.”
The reality is proven, alpha-producing alternative managers often have the leverage in fee negotiations. LPs are lined up to invest in top-quartile funds, so if an organization is complaining about fees, the managers will simply move to the next investor in line. As noted by PitchBook, in Q1 2017 there was over $55 billion raised by private equity fund managers, preceded by $51 billion in Q4 2016. This is one reason Yale claims, “In the leveraged buyout and venture capital asset classes, where top-tier firms enjoy intense investor interest for limited fund capacity, Yale is not in a strong position to modify economic terms.” It is estimated Yale has $8 billion invested in venture capital and buyout managers.
The solution Calpers detailed in the Wall Street Journal article was to hire in-house alternative portfolio managers. This solution is contrary to the Yale endowment and new Harvard Endowment strategy and many suggest will only attract those managers who are not capable of raising their own vehicles. And while Calpers is bringing managers in-house, others are doing the contrary. Forbes reported in January 2017, under the leadership of new CEO, N.P. Narvekar, the $35 Billion Harvard endowment would shift most of their investments to external managers. For many years, Harvard employed internal portfolio managers focused on specific asset classes. This shift in strategy will eliminate more than 100 jobs at the endowment. An excerpt taken from a letter written by Mr. Narvekar said, “…we must evolve to be successful.”
There is no doubt about it, the amount of fees earned by top-quartile private equity firms can, at first blush, appear unreasonable. However, they often look this way due to superior return generation, as the bulk of these fees have been earned on the merits of solid performance. If the fund performs poorly, the manager’s compensation drops accordingly. So, is Calpers making their case public as a negotiating ploy in their fight for lower fees or do they really think they can hire managers who can outperform the top rated emerging managers they have access to? Considering that David Swenson, the father of modern portfolio management who has also managed the most successful endowment over the past 25-years, makes a strong case for paying the fees of external managers, the members of Calpers will probably be better served if management stays the course.
What Do We Think?
Most often, management fee discussions only take place in the absence of performance. Managers that are willing to put their money where their mouths are have been gaining more and more traction with the LP community. By implementing investment return hurdles, liquidation preferences and first-loss strategies, managers are able to demonstrate a stronger conviction by transferring some of the performance-based risks from the backs of the LP to the GP. With these kinds of protective instruments in place, these managers are often able to charge higher management fees and carried interest. Especially in the hedge fund space, leery LPs are looking for unique tools to mitigate risk, while protecting their investors from overpaying for underperformance. What do you think?