Bain and the great fee debate

There were a couple of interesting takeaways from this week's news that Bain Capital is on the cusp of a final close for Fund XI, having gone past its $6 billion target (as revealed exclusively by PEI on Monday).

The first is what it means for Bain itself. The Boston-based firm hasn't had a particularly happy time in the last few years – partly because its former boss decided he wanted the world's highest-profile job, but also because LPs have been questioning the performance of its last two funds. Back in late 2012, LPs told us that the $8 billion Fund IX was showing a 6.9 percent net IRR, while the $10 billion Fund X (a 2008 vintage) was still under water. Although both vehicles were showing signs of improvement – and Bain’s long-established operating expertise clearly stood it in good stead during the downturn – that was quite a come-down for a firm that had always been considered top-quartile. And it clearly made life more difficult on the fundraising trail.

However, it looks as though Bain has found a way through those difficulties. Yes, the process was more protracted than some (having kicked off in the summer of 2012). And yes, the firm has ended up with a fund that’s substantially smaller than its previous funds (so it can be more ‘middle-market-centric’, according to one of its LPs). But it has at least beaten its target. And when that close happens, it can finally start to spend a bit less time worrying about external relations, and a bit more time worrying about which businesses to buy.

The other interesting point about this fundraise is what it says about terms. For years, Bain has been one of the few outliers to the prevailing 2-and-20 model, charging 2-and-30 instead  – and with some success, given that it raised five funds this way. This time round, however, it decided to offer LPs three options: a 1.5 percent management fee with 20 percent carry and a 7 percent preferred return, a 1 percent management fee with 30 percent carry and a 7 percent preferred return, or a 0.5 percent management fee with 30 percent carry and no preferred return.

Since LPs have long complained that management fees are too high, especially for the bigger funds (it was the most commonly cited sticking point in negotiations in our Perspectives investor survey last year), you’d expect them to go for the second or third option. But our LP source suggested that in practice, most investors would go for option one – because it’s “closest to market terms”. If he’s right, the net outcome may well be that one of the industry's only outliers ends up looking a lot more like everybody else.

It’s often said that there's been surprisingly little innovation in fund terms and structures in the thirty years or so since the introduction of the limited partnership model. There’s certainly been surprisingly little change to headline fees since the financial crisis: the average has inched down, but only barely, which few would have predicted back in 2008/9. And yet in this instance, where a GP has tried to innovate and offer a range of alternative fee structures, it clearly hasn’t been met with universal acclaim.

Indeed, however much investors grumble about fees, it doesn’t seem to affect their investment decisions all that much. And as long as LPs are not voting with their feet, GPs have little incentive to do anything about it. As Ed Hall, a partner at King & Wood Mallesons SJ Berwin, told us recently: “Investors don't generally select a fund because it has lower-than-market fees, so GPs don't generally have anything to gain by lowering [them].” At the moment, good funds can get away with charging pretty much what they want, while investors are unlikely to back weak funds just because they get a good deal on fees. So it’s hard to see the status quo changing any time soon.

A footnote: shunning different fee models isn’t necessarily just a question of practical convenience (though this is not an insignificant consideration in terms of diligence, comparability and so on). It may also be the wholly rational choice. In a paper published last year, academic Cyril Demaria of the University of St.Gallen in Switzerland suggested that a 1.5-and-20 model and a 1-and-30 one deliver more or less the same results to both GP and LP, on average.

Then again, he did also point out that top-performing GPs would probably be better off with a higher carry percentage. So it may be several years before investors in the new Bain fund know whether they’ve gone for the right option.