Private Equity Funds Cling to ‘2 & 20’ Fees

The vast majority of private equity funds still charge a 20% performance fee on top of “industry standard” annual management fees of 2% or more, research has shown.

Despite mounting pressure from institutional investors on private equity managers to reduce fees, Preqin’s research found that 85% of managers running commingled funds charged a 20% performance fee. In contrast, 48% of separate accounts had such a charge.

“General partners that adapt to the evolving fundraising environment will better meet the needs of limited partners and create long-term, mutually beneficial LP-GP relationships.”In addition, Preqin reported that 73% of buyout funds launched in 2014, 2015, or currently raising money had an annual management charge of 2% or more.

Nearly half (49%) of managers did not charge management fees on co-investments.

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Nearly a third of investors quizzed by Preqin said they were concerned about the level of performance fees, while one-fifth said they were worried about the appropriateness of fee structures.

However, Selina Sy, senior manager at Preqin, argued “some progress” had been made by managers to address fee concerns.

“Far fewer investors are concerned about the level of management fees at present, and at the same time, the proportion of investors that believe their interests are aligned with those of managers has risen significantly,” Sy said.

Investors are increasingly seeking “alternative routes to private equity,” she added, putting the pressure on traditional fund structures.

“General partners [GP] that adapt to the evolving fundraising environment will better meet the needs of limited partners [LP] and create long-term, mutually beneficial LP-GP relationships,” Sy said.

Ted Eliopoulos, CIO of the California Public Employees’ Retirement System, led the charge last month when he gave details to the pension’s investment committee about plans to overhaul and simplify its private equity program.

“What is an appropriate management fee? What level of profit-sharing adequately recognizes a manager’s skill and expertise and also fairly compensates the limited partner for assuming the risk? These are questions that deserve renewed attention and consideration,” he said at a public meeting in August.

Eliopoulos’ remarks came hot on the heels of a letter from representatives of several US public pensions to Securities and Exchange Commission Chair Mary Jo White urging regulatory action on private equity charging practices.

Smart beta and Benjamin Graham’s value investing may be cut from the same cloth, according to Research Affiliates.

Charles Aram, the firm’s head of EMEA, argued that value investing’s rules-based approach to security selection “supported by a firm’s financial strength, earnings, dividends, and assets,” can also be found in the heart of fundamental index strategies.

These qualities could be most attractive to those Graham identified as “defensive investors,” or those aiming to avoid serious mistakes and losses while seeking “freedom from effort, annoyance, and the need for making frequent decisions.”

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“The effective result is to sell securities whose price, and therefore capitalization, has increased over the year relative to its metrics, and to buy those securities that have had the opposite experience.”In addition to smart beta’s quantitative characteristics, its annual reweighting and rebalancing allows for “dynamic exposure to value and size factors,” Aram said.

Fundamental indexing strategies could extract excess returns from ramping up exposures to factors when they’re out of favor, and lowering those that may be overvalued.

Research Affiliates’ data supported these theses and found the fundamentals-weighted portfolios had a Sharpe ratio of 0.47 over the last 50 years, compared to 0.33 from cap-weighted portfolios.

However, Aram wrote that holding a contrarian position, whether it be value investing or smart beta strategies, could be difficult for many investors.

“These disheartened or fearful investors—possibly struggling with career risk or myopic loss aversion, or ultimately, just from the human condition—are often the other side of the trade,” he said. “Courage and conviction are often casualties of an ‘uncooperative’ market.”

The same “human condition” can be an investor’s worst enemy, Aram warned. Selling an underperforming security can hurt an investor’s total return, particularly if high fees are involved.

Aram also suggested investors not get discouraged by fundamental index strategies’ recent underperformance.

Heeding to Graham’s advice, investors should add to positions on the downside, as they can “lead to higher returns at later points in the economic and market cycles.”