Investor Base: Fee, fie

Current fundraising conditions are tough; that’s obvious from the number of firms coming in under target or switching to deal-by-deal funding. But new research by Private Equity International’s data division lifts the lid on exactly why it’s proving so difficult for managers to persuade LPs to part with their cash.

For a start, our survey – of 100 leading institutional investors, of varying sizes and in various geographies – suggests there is not a lot of new money about. Around three-quarters of these LPs said they have no plans to increase their current allocation to private equity, while nearly half want to reduce the number of relationships they have. Not terribly heartening statistics for firms actively trying to expand their investor base.

However, perhaps the most significant sticking point at the moment – perhaps unsurprisingly – is fees. Investors are increasingly demanding a better deal, and they’re not afraid to walk away if they don’t get one: 87 percent said that high management fees and/ or carried interest constituted a valid reason not to invest in a given fund. What’s more, 38 percent said that was true even for strong managers with an impeccable track record – a result that would have been unthinkable during the boom years, when the top GPs were able to charge pretty much whatever they liked.

As a result, the standard 2-and-20 model is becoming the exception rather than the norm. Around 80 percent of respondents argued that a 2 percent management fee was no longer acceptable in the current climate, with the majority calling for fees of 1.5 percent or lower (more than two-thirds of respondents cited this as a fair level). In fact, some LPs are opposed to any kind of fee based on a percentage of commitments – George Sudarskis, founder of Sudarskis & Partners (and former PE head at ADIA), spoke for many by arguing that fees should be calculated on the basis of costs, not the size of the fund. This practice might not be widespread yet, but it’s bound to become more so as the competition for capital hots up.

In addition, LPs are increasingly seeking some kind of flexibility on the headline rate. For the biggest investors, that could mean some kind of separate account arrangement with favoured GPs: although only 11 percent of our respondents do this already, a further 17 percent are considering it. 

Early-bird discounts are also popular: 64 percent argued that they should get a fee break – of somewhere between 10 and 25 percent – for signing up early. Some added that they shouldn’t have to start paying any fees at all until the fund is at least half-way to its target. 

Similarly, 90 percent of respondents said that fees should drop after a fund’s investment period has concluded. At a time when the vast majority are getting requests for fund extensions, this is clearly a hot topic; unsurprisingly, LPs are nervous about being lumbered with zombie funds, where GPs keep collecting their management fees even when they have no prospect of getting into carry. As a result, GPs offering fee structures that mitigate against that prospect are likely to be an advantage.

The other consequence of this drive to reduce fees is that LPs are trying to cut out middlemen wherever possible. That means reducing their use of funds of funds: 20 percent of our respondents said they do this at the moment, but only 11 percent expect to do so in the future. On the flipside, co-investment is getting more popular: 22 percent said they already do it, but a further 27 percent said they were actively considering it. This illustrates the same point: if an LP has the resources and the wherewithal to strip out a layer of fees without it affecting returns (or even improving returns), that’s what they’ll be looking to do in the current climate.

Even hurdle rates are under scrutiny. Although LPs seem happy with an 8 percent preferred return in developed markets, there was some suggestion that it should be higher in emerging markets – to reflect the fact that it’s possible to achieve this kind of return with lower risk in more liquid products. Then again, others argued that “the problem is not the hurdle, it’s the catch-up”. (See p. 21 for an in-depth discussion of this point).

So the overall picture painted by this survey is very clear: most LPs believe they should be getting a better deal from GPs, and in the current climate, they’re increasingly unwilling to settle for less. 

The question is: will this result in a complete sea change? The top managers – those who offer the best prospect of top-quartile performance at a time when returns are hard to come by – will still be in high demand, and thus will have little incentive to reduce their fees substantially. But the also-rans certainly will – and GPs across the board are going to have a much harder time enforcing the kind of one-size-fits-all policy that they’ve been able to get away with in the past.