By Hamlin Lovell, NordicInvestor
Minor fee pressure apparent in some segments
It very clear that fees have, for many years, been falling on traditional, long only investments, and also on relatively liquid alternative investments, according to the annual EY Hedge Fund Survey, which was this year renamed the EY Alternatives Fund Survey. Yet the headline fees for illiquid investments, such as private equity and infrastructure, appear to be much stickier – just as the assets are.
Headline averages may not be the most useful indicator of change for private equity funds however, due to the long duration of capital. When ETFs cut fees, the average comes down pretty much overnight. But when newly launched private equity funds start offering lower fees, that hardly moves the needle in terms of averages, because most funds in any survey will have fixed their fees when they launched many years ago. The latest vintage will only be a small percentage of the sample, like the tip of the iceberg. Therefore, to try and get a feel for any changes, it may be worth digging out surveys that focus specifically on new funds.
Different surveys can shed light on various market areas.
The 2017 Preqin Private Capital Fund Terms Advisor said that, “Unlisted infrastructure funds have seen mean management fees rise marginally from lows of 1.38% for 2014 vintage funds to 1.48% for 2017 vintage funds and vehicles in market…Across the same period, closed-end private real estate funds have seen average fees go from 1.41% to 1.57%. Similarly, private equity buyout funds have seen their mean fees rise from 1.85% for 2015 vintage funds to 1.94% for 2017 vintage and raising funds”.
The annual MJ Hudson Private Fund Economics survey gathers data from a mix of private equity, infrastructure, real estate, growth capital, venture capital and private debt funds, domiciled in the US, UK, Europe, and offshore locations such as Cayman Islands, Channel Islands and Mauritius.
The 2018 survey found that these managers cannot necessarily take 2% management fees for granted. “Funds charging a 1.5% management fee scooped 59% of committed capital” and the average capital-weighted management fee is now 1.49%, the survey found. There is a wide spread, with 16.9% of funds charging management fees below 1% and 11.9% charging above 2%.
However, it is mainly large-cap funds that appear to be cutting their fees. The small and mid-size funds are still charging around 2%, while half of the venture capital funds surveyed charged above 2%.
Anyway, the average headline fee also ignores fee discounts, which may be offered for one or more of: larger allocations; longer lockups; for seeding new funds, and co-investments whereby limited partners are invited to invest directly into certain deals.
Performance fees for private equity are usually called “carried interest”, and here the 20% level seems to be more stable than the 2% management fee: some 85% of the funds surveyed by MJ Hudson charge 20% carried interest.
This can sometimes even increase, or ratchet up, after certain performance milestones are achieved. Some funds could be getting as much as 25% or 30% of performance above certain levels.
However, in one respect, performance fee structures on private equity may superficially appear to be more competitive than on some hedge funds. Despite interest rates being at record lows, carried interest generally only applies above a hurdle rate of 8%, the survey found. There is a range though, with 4% the lowest hurdle seen and 10% the highest.
However, the catch is that “catch up” is near universal: once the hurdle rate is surpassed, the carried interest applies to returns both above and below it. Therefore, the hurdle is conceptually more of a trigger than a hurdle. It is very rare to see private equity funds that do not actually charge a performance fee on the part of returns below the hurdle, if the hurdle is met. In contrast, some hedge funds do have a hurdle, usually defined by interbank interest rates, below which they do not receive performance fees.
An interesting nuance is that investors are sometimes being offered the option to trade off a lower management fee for a higher performance fee, or a higher management fee for a lower performance fee. The menu approach lets managers cater for allocators that face different constraints and preferences.
Non-fee costs on private equity funds can be higher than on other vehicles, and can cover activities such as administration, advisory, deal-related, deal-monitoring, and operational functions including back office support. Private equity managers can also receive transaction fees from the companies they invest in. Fee structures can become very complicated, with partial offsets between different fees. The lawyers who draft fee terms do their best to be clear, but there can be differences of opinion and interpretation over how fees are described in various documents.
Non-fee issues have attracted the attention of regulators. The US SEC in April 2018 published a report called “Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers”.
This identifies cases where fees have not been disclosed, or allocated, in line with documentation or regulation or both
There have been a number of public cases where regulators have alleged private equity funds were not allocating costs, such as those associated with broken deals, fairly, or consistently with what was set out in documents. For instance, distribution and marketing fees, regulatory filing fees, and travel expenses, have also sometimes been allocated to clients, instead of being borne by the manager.
Guidelines, templates and standards
One source of potential confusion that makes it difficult to make comparisons between managers is that different private equity managers report their fees and costs in different ways, using different formats, labels and templates. Therefore, there are pressures for standardization.
Industry standards of best practice may help managers and investors to improve the quality of reporting on fees and costs, and to standardize it so that investor can compare funds on a common basis.
In Europe, Invest Europe (formerly EVCA) has developed reporting guidelines, the 2018 Invest Europe Investor Reporting Guidelines, which have special sections devoted to the specific needs of market segments such as venture capital, funds of funds, infrastructure and secondary funds.
In the US, ILPA (the Institutional Limited Partners Association) has devised a template for reporting fees, expenses and carried interest, which goes well beyond standard reporting packages.