Reading this paper got me thinking, is there any way to justify the fees charged by PE firms for their funds? If you look at the worked example in table 1, you can see the fees amount to 7% per annum. That is fairly common for a PE fund while it would be unheard of for a mutual fund. The author of the article is an academic who has looked at the issue in some depth. He has also compiled one of the largest databases of PE fund returns to date and concludes that PE funds have earned gross returns in excess of the major equity indices but significantly underperformed on a net basis. http://www.rau.ro/intranet/JEP/2009/2301/23010147.pdf The most outrageous part of the fee structure for me is paying 2% management fee on the committed capital in the early years of a fund and not on what has been drawn down. So you commit $10m to a fund and in year one you will pay a management fee of $200k even if only $1m has so far been drawn down. So in year one your real management fee is in fact 20%. Any comments from people in the industry? Anything I’m missing that might mitigate the seemingly high fees here?
Diversification?
No, you are right on. Look up some papers on the Public Market Equivalent (“PME”) measure of private equity returns. You’ll see that when taking into account fees, on average, private equity strategies do not outperform public market equities.
Who do you need to justify the fees to? If the investors don’t like the fees, then they won’t invest.
DB - I agree. In reality, PE firms will continue to charge these sorts of fees as long as investors are willing to pay them. As KK says, the studies done to date on PE fund returns suggest that after fees most investors would have been better off in an equity index ETF. Gross of fees, returns look pretty good. I imagine in time, investors will begin to negotiate better deals where fees are kept to a more reasonable level. The largest pension funds, endowments and sovereign wealth funds have the most bargaining power due to their size so they should start the trend. Perhaps some of these funds already have rebate agreements in place but they are not publicly known.
Sometime in early 2006 when I was in PWM, a client came to us with a prospectus for a fund. The fund was organized by Wachovia, and was going to charge something like .25-.5% just to invest all its assets into a Lehman PE-FoF. The Lehman fund took the standard 1-10, and the underlying funds charged 2-20 or more. The Lehman fund did have all the big names - Blackstone, TPG, Silver Lake, etc. The rub was that the Lehman fund had a minimum investment of $5M - a big hurdle even for the mildly wealthy. The Wachovia fund had a min of $250K - not too bad. We noted that through all these fees, hardly anything was going to trickle back to the LPs, but it didn’t matter. The LEH fund did have a great track record, and that was all the client saw. The big guys do have significant negotiating power with the funds, especially now (not so much in 2007). Even more so with hedge funds, where they can get greatly reduced fees in exchange for multi-year lockups.
Are they tax efficient somehow, thereby driving up the real rate of return? IE deferring taxes/reducing your tax bill is an added return/incentive. They are certainly long term investments and should be viewed in terms of the long run. Also, as TP mentions, it can be about diversifying your source of returns for institutions. Finally, I dont know the market well, but it could be that we are just at a point in the cycle that isn’t great for PE. Think numi will chip in somewhere - he is in PE.
The fee on committed is to pay the overhead in research/due diligence done upfront to select the investments and close the acquisitions. Not sure about other assect classes, but the due diligence is significant in real estate.
I remember in my earlier job at a Big4 I did a Due Diligence on a company that had been LBO’d. On the operations side it was a great business, solid CF from operations, but debt service ate everything so that the company had negative CF in the end. Anyways, these PE dudes were raking in huge management fees (that were not subordinated at all, i.e. were just a normal expense of the company), despite the fact that the company was going to need a haircut.
I attended a CFA society lunch event recently that focused on evolving PME strategies. It was fairly interesting, but the guys pitching it wouldn’t delve into their strategy. PE fees are astronomically high. They make a variable annuity look like the Vanguard S&P Fund. There’s a reason why 25 year olds in mega funds can pull down $300k in a good year and it’s not because of their success. All in all, I think the glam of the PE industry has started to fade and most investors are much less apt to pay for PE.
I’m not that knowledgeable about PE, despite growing up in Silicon Valley. From what I’ve read here and elsewhere, it sounds like it’s similar to convincing people to buy bottled water “Because it’s so much better than the other stuff you can get.”
The management fee is used to “keep the lights” on and for employee salaries. You need employees to drum up deal flow, do the analysis, and for back office etc. Also while management fee is charged on whole commitment the LP earns a return on the undrawn amount through their own investing activities.
Dapper425 Wrote: ------------------------------------------------------- > The management fee is used to “keep the lights” on > and for employee salaries. You need employees to > drum up deal flow, do the analysis, and for back > office etc. Also while management fee is charged > on whole commitment the LP earns a return on the > undrawn amount through their own investing > activities. Those are some mighty expensive lights. Figure a firm with $1B AUM. 2% is $20M/PA. Firm should have 8-10 investment people, and perhpas 20 BO. The BOs average out to 60K each - that’s $1.2M. Investment types will be about 2 partners @ 300K, 4 VPs @ 200K, 4 associates @ 100K (numbers are fully loaded base + benefits). That’s $1.8M. That’s $3M. If you spend $1M on overhead on a firm of this size, you’re living well. I’ve accounted for $4M out of 20. Even if I’m too low by half, I’m still having a tough time figuring out where the $20M goes. Don’t say deal fees or diligence, because the lion’s share of that will be reimbursed by the acquired companies or paid by the fund directly.
2% sounds rich to me. can someone confirm that’s actually the market? certainly not in the RE space.
Nakedputs: I mostly agree. I think for a fund of that size management fee might be closer to 1.5% but I am curious to hear what others have to say about it. Obviously there are great economies of scale to this business model which is why it is so attractive to the partners. Whether you have $100mn AUM and make 20 investments at $5mn each or $1bn AUM and make 20 investments at $50mn each you need about the same size staff and the same amount of effort. However your management fee is 10x bigger in the latter case. I think a fund of this size would have more partners and fewer VPs than mentioned above but to his point there would be plenty leftover. I think people may be paid about 20% - 30% more as well in a fund that size. Ok so where frequently does this leftover money go: 1. Placement agent - A Placement agent is going to bang you two points for raising the capital. On $1bn that’s $20mn. Assuming the firm has 5 general partners each has to pony up $4mn. 2. GP contribution - The GP will be required to contribute at least 1% of the capital. Usually this can be offset by management fee. So assume they put in 2% which is very reasonable. That’s another $20mn. 3. Keep in mind the full management fee is usually only collected for the investment period. Typically 5 years. Thereafter it is based on a % of outstanding capital.
As if on request: http://www.pehub.com/102914/fund-terms-grow-sweeter-bain-expected-to-offer-20-carry/
We deal with PE offering very often. When you look at the industry (PE) return, there is a huge range in the manager’s annual return (if they report it), the gap between top manager to lower-tier manager is very wide. Therefore, it tell you that PE investing is a skill-intensed business. People, operation and due dilligence play a hugh part. So, IMO, the 2-20 fee sturcture is justifiable when you do direct PE investing. However, I don’t buy the FoF PE approach…diversifcation my ass, all they are doing is diversifying alpha away…THAT, I have a problem with the fee at FoF level.
NakedPuts Wrote: ------------------------------------------------------- > Figure a firm with $1B AUM. 2% is $20M/PA. Firm > should have 8-10 investment people, and perhpas 20 > BO. The BOs average out to 60K each - that’s > $1.2M. Investment types will be about 2 partners > @ 300K, 4 VPs @ 200K, 4 associates @ 100K (numbers > are fully loaded base + benefits). That’s $1.8M. > That’s $3M. If you spend $1M on overhead on a > firm of this size, you’re living well. I’ve > accounted for $4M out of 20. Even if I’m too low > by half, I’m still having a tough time figuring > out where the $20M goes. Don’t say deal fees or > diligence, because the lion’s share of that will > be reimbursed by the acquired companies or paid by > the fund directly. I think your comp numbers are extremely light. You’d be shocked at the percent of peeps that make 200-300k at relatively junior levels at buyside shops.
Danny Boy Wrote: ------------------------------------------------------- > NakedPuts Wrote: > -------------------------------------------------- > ----- > > Figure a firm with $1B AUM. 2% is $20M/PA. > Firm > > should have 8-10 investment people, and perhpas > 20 > > BO. The BOs average out to 60K each - that’s > > $1.2M. Investment types will be about 2 > partners > > @ 300K, 4 VPs @ 200K, 4 associates @ 100K > (numbers > > are fully loaded base + benefits). That’s > $1.8M. > > That’s $3M. If you spend $1M on overhead on a > > firm of this size, you’re living well. I’ve > > accounted for $4M out of 20. Even if I’m too > low > > by half, I’m still having a tough time figuring > > out where the $20M goes. Don’t say deal fees > or > > diligence, because the lion’s share of that > will > > be reimbursed by the acquired companies or paid > by > > the fund directly. > > I think your comp numbers are extremely light. > You’d be shocked at the percent of peeps that make > 200-300k at relatively junior levels at buyside > shops. My numbers are base only. You shouldn’t (doesn’t mean nobody is) pay bonuses from the management fee.
Sorry, after rereading your post I see that you did not include bonus. I interpreted “fully loaded base” incorrectly.