AGENCY PROBLEM(2)

Despite the many doomsday scenarios painted by some outside the industry, private equity is an entrenched institutional asset class, and recent trends indicate that it will become bigger and more entrenched.

The same institutions that are increasing allocations to private equity are also shifting their perception of what private equity is. Those LPs who have built up portfolios over the past decade see private equity less as a set of exotic strategies and more as the yin to the public market's yang.

Case in point – a private equity portfolio manager at a major state pension recently told me that he views his institution's overall portfolio as naturally flowing between two worlds. The equities of public companies are managed in one part of the portfolio. Those companies that might see more value realised under private ownership move to the private equity area. Once the companies have completed their sojourn in private equity they move back to the public equity side of the building.

Indeed, one important observation amid the wave of private equity-backed takeprivates has been that the underlying institutional ownership of many of these companies doesn't change radically when an asset moves from public to private hands. A corporation whose shares were owned by a large money manager on behalf of a large state pension goes on to be owned privately by a consortium of private equity firms, one or more of which are probably investing on behalf of the same large state pension.

So long as institutions see the benefits of this cycle of birth and rebirth, private equity will enjoy a thriving future, as more and more institutions clamour to participate in the corporate governance magic that takes place when a company has been freed from public ownership.

However, as they cycle through the great yin of private equity, the limited partners are confronting what can only be described as an agency problem in the form of management fees.

The history of LP-GP relations is generally a history of progress with regard to the alignment of interests. The 80/20 profit split is, of course, the powerful magnetic center of alternative investments, drawing all strategies into private partnerships where everyone's fortunes are supposed to rise and fall in tandem. But it has taken some time and struggle to get the profit-sharing formula just right. An early struggle was around the deal-by-deal calculation of carry. In other words, “heads we both win, tails you lose.” Today fund-as-a-whole carry calculation is the norm: LPs benefit from it, and therefore the industry as a whole benefits.

The second struggle was over deal fees. General partners would buy a company on behalf of the LPs, but then charge the company millions in consulting fees that went straight into the GPs' pockets. In some cases the GPs made more money on the deal fees than they did via carried interest. Recognising that this imbalance could create perverse incentives for the GPs to buy any old company and watch it go sideways for a few years, LPs fought back and now the bulk of deal fees are shared with LPs, typically through an offset to the management fee.

Which brings us to the final barrier that LPs have yet to break through – the mega management fee. While other terms in the partnership have mostly evolved in the LPs' favour, this term seems to have done the reverse. Originally created as a simple mechanism for paying expenses, the fund management fee is now a major source of wealth for GPs. By one calculation, a firm with a $15 billion fund can make $200 million per year in management fee income. This is on top of the several billion in assets already producing a fee stream and going to the same group of professionals. This is good for GPs but bad for LPs.

Although no GP will claim the practice takes place at their own firm, a growing number are certain that other private equity firms are factoring management fee income into pricing models. LPs, too, worry that firms are internally justifying return-killing high bids because winning big deals leads to raising bigger funds leads to higher fee income.

The elegant solution: operating budgets instead of management fees. To be sure, getting there from here will be the greatest LP-GP struggle of all – if a struggle ever ensues: to date, LPs have paid little more than lip service to this crucial issue.