Death of the carry?

Anyone who thought it was tough making money on the direct investment side of the private equity industry should take a look at the fund of funds scene.

The heady days of the late 1990s, when the fee structure on many new funds of funds incorporated double-digit carried interest, are long gone. A two-tier market has emerged in the fund of funds sector, where the big, established managers don't need to charge carry, and the new, small players are in no position to. ?I can't imagine any sane person launching a new fund of funds in this market,? comments an established fund of funds insider.

It's not as though money has stopped flowing into the sector. In November, Boston-based private equity fund of funds giant HarbourVest Partners held a final close on its hybrid direct investment/fund of funds, HarbourVest International Private Equity Partners IV, on $2.8bn. Also in November, Goldman Sachs closed its latest private equity fund of funds, GS Private Equity Partners 2002, on $1.2bn, well in excess of its original target of $750m. And in July, New York-based private equity investment manager Abbott Capital Management closed its fourth fund of funds, Abbott Capital Private Equity Fund IV, on $730m.

However, these were funds raised by established firms with track records and strong reputations. Newcomers are finding the fundraising environment much harder to negotiate. On the venture capital side alone, 22 funds of funds raised only $4.2bn in 2002, according to research firm Thomson Venture Economics. In 2001, 78 VC funds of funds raised $14.2bn. That's a drop in funds raised of over 70 per cent.

No more carry on top of carry
These trends have emerged in part because the fund of funds market was over-inflated at the peak of the boom and was responding to a very different type of investor. According to Brooks Zug, senior managing director of HarbourVest Partners, his firm decided against imposing a carry on its debut fund of funds in 1982. ?The sophisticated institutional investors didn't want to pay an incremental fee when, in most cases, there was already a 20 per cent carry in the partnerships we were investing in,? he says. ?They weren't willing to invest in a fund of funds if it involved a carry on top of a carry.?

The introduction of carry as a component of funds of funds management fees was a reflection of the prevailing conditions at the market peak of the late 1990s. ?The reason carry was put in place originally was that when these new funds of funds were being raised they could only put together a couple of hundred million dollars in assets under management, and that was not enough to pay for a full team,? says a source at one of the larger FoF managers. ?People didn't mind working for peanuts in the short-term, but they wanted some upside.?

Zug says that nearly all of the new funds of funds that were formed at the peak of the market are affiliated with financial institutions ? commercial banks, investment banks, insurance companies ? which launched funds of funds to serve a client base, much of it high net-worth, anxious to find a way to invest in private equity. These sponsors were institutions with sales forces to maintain and with individual clients used to a higher fee structure than the institutional market. As such, they were able to charge higher fees and, in many cases, a carried interest.

The results were predictable. According to one prominent fund of funds manager: ?There was a near algae bloom some years ago of people coming out with funds of funds because they thought this was a great way to lock up assets and get paid fees for a long time. They thought, ?how hard is it, anyway, to execute?? The first two are correct, the last part is wrong. And a lot of people went out with shabby programmes and didn't get very far.?

Has this bubble significantly impacted fee structures managers are setting for their fund of funds vehicles? Analysed over time, management fees and hurdle rates have remained fairly flat over the past four years. But the average primary carry has trended downwards.

According to an analysis of 17 North American and European funds of funds by a prominent fund of funds manager, management fees tend to average 100 basis points for institutional investors, and are slightly higher for high net worth investors.

Carried interest terms for FoFs now average five per cent, although there is much diversity, with terms ranging from no carry whatsoever on large commitments up to as high as 10 per cent in some cases, again skewed slightly higher in the terms for high net worth individual investors. The fund of funds manager who conducted this analysis says he has noticed that newer funds are much less likely to charge carry.

However, smaller investors are more likely to have access only to vehicles that charge higher fees. According to Louis Singer, a partner in the private finance team at the New York office of law firm Orrick Herrington & Sutcliffe, this is a result of basic economies of scale, with the larger fund of funds not wishing to bother with tiny investors, whereas newcomers need to aim low with the intention of growing bigger.

?If you get into separate accounts, where people are committing north of $100m, then obviously managers are able to price a little more aggressively,? one manager says.

?There are some segments of the market ? not ones we're particularly interested in ? that routinely offer lower fee structures,? comments a source at one of the heavyweight FoF managers. ?For example, a lot of the public funds ? the ?PERS? and ?STRS? of the world ? put tremendous pressure on fees. There are people who offer products for that market and are willing to accept the fee structures demanded.?

Bigger fees for the specialists
There are three specific investment specialties where fees and carry are markedly higher than the fund of funds market average. The first is funds of funds dedicated to secondary investments. The average carry on a secondary purchase could be 10 per cent or higher, according to a market source. The second is funds of funds dedicated to co-investments, where the carry is in the same range as that charged by buyout funds – up to 20 per cent.

An additional opportunity for funds of funds managers to charge higher fees is when they operate in emerging markets, where the additional risk demands additional expertise.

But when it comes to common or garden funds of funds, pension plans and other sophisticated institutional investors are no longer prepared to pay both a double carry and a full management fee. ?The retail market will still pay a carried interest, but the more sophisticated market, essentially, is toast,? says one industry insider.

Some managers in search of investors are resorting to lowering their investment minimum threshold. ?Fund of funds sponsors are willing to look at smaller contributions, to what I would consider classic high net worth territory, around $200,000,? says Stuart Waugh, managing director at TD Capital Private Equity Investors. Waugh notes that his firm raised the bulk of its recent debut third party fund of funds from Canadian institutional investors, but also received 10 per cent from high net worth investors in Canada.

High net worth investors may accept higher fees, but they are also more likely to be high-maintenance investors. ?The high net worth investors tend to require as much client services attention on their $500,000 commitment as a big, more sophisticated institution needs that has given you $50m,? Waugh says.

In the final analysis, says Phil Cooper, head of Goldman Sachs Asset Management Private Equity Group, ?you get what you pay for. The fragility of many of the offerings has been shown under the pressure of market conditions, and there has been a flight to quality, to what people perceive as better-designed and executed programmes.?

HarbourVest's Zug estimates that ultimately as many as half the new fund of funds operators who entered the market at its peak will not raise new money. ?When the economy starts to return you will generally see fewer funds of funds because there were too many, and too many of very marginal quality,? says Cooper. ?The funds of funds industry, I expect, will undergo consolidation. The people with better and more robust programmes will survive.?

Fees three ways
Even without carried interest, the following three (real) examples offer some indication of the tremendous diversity in management fee structures built into private equity funds of funds currently under management:

1. A 0.5 per cent management fee (based on capital commitments) for the first year, rising to 0.75 per cent in the second year and 1 per cent for the next six years. Then the fee begins to step down, falling 10 per cent from the prior year each year thereafter.

2. A 1 per cent management fee for capital commitments up to $25m, a 0.9 per cent management fee for capital commitments of $25m to $50m, and a 0.75 per cent management fee for capital commitments of $50m to $150m. For amounts above that level, the management fee is 0.50 per cent for the first seven years, stepping down in 10 per cent increments from the prior year each year thereafter.

3. A 0.25 per cent management fee on capital commitments for the first six years, falling to 0.215 per cent for years six through nine, and 0.175 per cent for subsequent years.