Future returns: private market funds earn more in fees
Financial advisers to the wealthy view private market investments as a way for investors to diversify and earn higher returns than are often available in public markets.
But investors should also consider the impact of fees on their returns when investing in the US$7 trillion market of private equity, private debt and venture capital funds. A recent analysis by London-based data and analytics firm Preqin found that larger private market funds generate more fee income as these vehicles get larger and add more layers of fees.
“A lot of investors wonder where these fees go? What do we give to these private equity firms, which seem to be getting bigger and bigger and making more profits? says Charlie McGrath, author of a Preqin analysis titled “Sticky private equity management fees hide the dollar cost.”
McGrath’s report was based on data from Colmore, a subsidiary of Preqin that tracks private market vehicles for sponsors, investors in these funds. Private market fund managers are known as general partners.
For this analysis, Colmore provided Preqin with anonymous data about the fund fees they collect so that they can inform sponsors whether the fees they are charged are in accordance with the fund’s legal agreements, Paul O’Shea said. , senior vice president at Colmore.
Clients requesting this service are typically large institutional investors, such as pension funds and insurers, who typically invest in funds of at least US$1 billion or more.
The American Investment Council, a private equity trade group, counters that the sector plays a central role in the economy and that the returns generated by this asset class justify the fees. The California Public Employees Retirement System, or CalPERS, invested in private equity funds that returned nearly 40% last year, the investment board said in a February report.
“Private equity invested a record amount – more than US$1 trillion – across America in 2021, helping to strengthen pensions, support small businesses and fuel economic recovery,” said a spokeswoman said in a statement. “Pension funds understand that private equity is an essential part of a diversified portfolio and offers higher returns, net of fees, than other asset classes.”
penta recently spoke with McGrath and O’Shea about analysis, what investors should know, and how regulators are beginning to emphasize private market practices.
Rising costs for investors
Investors in private market funds typically pay on what’s known as a 2 and 20 fee structure. The “2” refers to a 2% management fee charged to an investor on dollars committed to a fund. supposed to cover salaries, overhead and other administrative expenses.
The “20” refers to the percentage of profits given to the fund manager – known as the general partner – once the fund has reached an annualized performance threshold which is usually 8%.
Percentage management fee levels fell slightly to 1.68% in 2020 from 1.70% 10 years earlier, but, Preqin points out, fund sizes have increased significantly over this period. This means that, overall, the general partners of these funds receive more dollars as their funds grow.
For example, funds with vintages between 2018 and 2020 had an average of $5 billion in assets, compared to an average of $2.6 billion for funds with vintages between 2009 and 2011, according to the report. In absolute dollars, the new funds raised US$88 million in annual fees, compared to US$44 million in annual fees for older funds, Colmore found.
“The idea has always been that the management fee would cover the costs, keep the lights on, and managers should earn their real money through performance, carry, 20% payout,” says O’Shea. “But they also get rich from management fees.”
In addition, says O’Shea, fund profit percentages increase to as high as 30% in the case of some venture capital funds.
New fresh layers
Of most concern to O’Shea is the fact that a number of private market fund managers have shifted expenses that were covered by management fees to a new set of fees.
A survey by the Institutional Limited Partners Association, a trade group representing private market investors, found that the management fees for many funds did not cover expenses such as day-to-day administration of the general partner, travel to source investments, salaries and office overhead.
“Instead, these expenses are paid for by the partnership, or fund, outside of the management fee, creating a ‘2 and 20 plus’ arrangement,” according to McGrath.
While some fund managers offset those costs with advisory revenue received from the companies they invest in, others have narrowed the scope of what portfolio revenue like this can cover, McGrath said in his analysis.
Some funds also charge another layer of one-time fees to cover the cost of setting up the fund. These fees, assessed as a percentage of each investor’s dollar commitment to the fund, may seem small in percentage terms, but they can also result in large overall dollar contributions as the size of the funds increases. -he declares.
While these fees are generally capped, the caps have increased and some funds charge expenses outside the cap to the partnership, the report says.
In search of more transparency
An industry advisory body for investors called the Institutional Limited Partners Association has created a voluntary form that general partners can use to break down the fees paid and why. While helpful, it’s not mandatory, and some fund managers fill it out and some don’t, says O’Shea. Or, he says, they’ll fill it for some sponsors, but not others.
“They have the ability to do it, but they choose not to,” he says.
Although the United States Securities and Exchange Commission does not adopt the form of association as a requirement, it is pushing for greater disclosure of private market funds, including hedge funds, so that regulators can better assess the potential risks that funds may pose to investors and markets. The European Securities and Markets Authority is also taking a closer look at private market funds.
On Feb. 9, the SEC proposed an amendment to existing regulations that would, among other things, require registered private fund advisers to “provide investors with quarterly statements detailing certain information regarding fees, expenses and fund performance.” In Preqin’s view, the fact that funds continue to earn ever-higher management fees shows that investor concerns have no effect on the fees charged. But, as McGrath points out in his analysis, “with regulators officially joining the fight, [limited partners] can see movement and clarity as they continue to allocate capital to private funds.