Working hard for the money?

They are under starter's orders here at Bear Market, in the first race of the new season. Betting on the race has been keen with some big money backing the horses and the jockeys. However, the punters are wondering out loud whether the owners are not taking too big a cut for themselves. After all what is it exactly that they do? The horses do the running and the jockeys steer the way. It is not immediately evident on race day what contribution the owners make. On race day even the weather seems to make more of a difference to the race's outcome.

Similar doubts are being expressed by the investment community of its private equity managers. Private equity managers that used to talk about backing the jockey and not just the horse, or in investment terms, the corporare management and not just the company, are finding it hard to deliver the returns now that the going is less good. To put it another way, the climate has changed and the economy looks set to rain on the private equity industry's best laid plans.

Some investors, and even managers, argue that the last ten years have given everyone an easy ride. For the punter it was a question of backing enough big names and the winners would just keep romping home. And while the going was good and the net returns high, it did not seem to matter how much the owner creamed off the top, the back and the sides. Some US funds, particularly hot venture capital funds with investors queuing to commit capital, were stipulating carried interest as high as 30 per cent at the top of the market.

Now that the bear market is well and truly with us, investors in private equity are starting to ask questions. Observers of the industry have noticed a slow down in investments, realisations and fund-raising, both pre- and post September 11. For the private equity houses, the money may not be running out the door as it did 18 months ago, but neither is it in most cases flooding in. Times are tough and some are predicting blood on the board room floor. Or perhapsa pile-up at the final hurdle.

Kerrin Rosenberg, a partner with investment consultants Bacon & Woodrow in its private equity practice, paints a dark picture of the situation in the US, which may have lasting repercussions for the industry. The ditch before the fence is the annual management fee charged by private equity firms.

Larger funds, same fees?
Rosenberg says there were any number of US firms with small funds and good returns, which in the bull market had quickly found themselves on a roll. He says: ?They were going back to investors raising a $1bn fund, which they invested in six months and then went back for more. My fear is a lot of that money has been thrown away.? Rosenberg is nervous that the funds raised in 1998 and 1999 may undo the careful work of decades and send the pension funds running from the asset class.

His gripe is that the firms made no adjustment to the management fee which was 1.5 per cent when they were just six executives running a $300m fund and remained 1.5 per cent now the same six executives were running a $1.5bn fund. They were doing the same number of deals, just bigger. He says: ?I worry at the quality of those funds. What will be bad, if they go bust, is that the guys who ran the fund, earning between $30m and $40m a year in the management fee, will walk away wealthy people. Something has to come back from the fees. Or the pension funds will hurt.?

Aside from any hubristic fall-out from the high-spirited 18-months, which characterised the dot-com bubble, there is the question of motivation. Bigger funds tend towards bigger deals, which generate economies of scale. Annual management fees that are disproportionate to the effort required to manage the investments can, investors argue, kill the financial incentive. Fading super models, who would not get out of bed for less than $10,000, might well consider a job at a private equity firm where the fund has grown exponentially but the staff has not. An annual management fee of $42m, or 1.5 per cent, from a $2.8bn fund will roughly generate for 12 partners $10,000 a day each. That is before they've done a deal. (Obviously it's also before costs. Once these are factored in, the models would certainly be having second thoughts.)

If a fund goes bust, management may still walk away wealthy people

Investors are wondering whether instead of the fees it should be professional pride and the desire to raise future funds providing the main incentive for GPs. Alex Scott, senior investment manager with the West Midlands Metropolitan Authorities' pension fund, says: ?We want to see the fees spent. They shouldn't be a profit centre. The incentive should come from carried interest.?

The problem, according to Rosenberg, is that private equity managers have not evolved in the same way as their counterparts in quoted equity. Managers of quoted portfolios have a sliding scale: the more money the lower the fee and the fee is capped at a certain level. Private equity managers have claimed the high ground of outperformance, but they may have built themselves up for a big fall.

Caveat emptor
Ivan Vercoutère of LGT Capital Partners, the Liechenstein-based alternative investment group with €2.6bn under management, views the issue of fees differently. He says: ?At the end of the day fees are driven by the market. They reach the level of whatever the market will bear.?

Vercoutère believes that the private equity market is like any other market and the Latin maxim of caveat emptor, or buyer beware, holds just as true. It is just as easy to pay a bad manager a lot of money as it is to pay the best manager and an investor will be paying roughly the same amount for both. One of the age-old problems with private equity is the wide dispersion between upper and lower quartile performers. The trick for an investor is to pick the upper quartile performers because they probably will not cost you any more.

Scott says there is almost a comfort factor in the amount funds charge: ?If it is cheap, it is cheap for a reason.? And whilst he does not dismiss the issue of fees, he does not see them as the deciding factor in manager selection: ?Primarily we look at performance. Fees and carried interest are a drag on performance. But it never comes down to just the fees, as long as they are within a range that we are comfortable with.?

Sue Scollan is a senior fund manager at Morley Fund Management, which runs the £600m private equity portfolio for CGNU, its life assurance parent. She too likes to see the bulk of a manager's reward coming through its performance rather than from the management charge. She says: ?At the end of the day what we are trying to get is good net returns. As long as that net figure holds up against the alternatives for that capital allocation, then that is why we do private equity.?

This is another of Rosenberg's bugbears, however, with an industry he thinks may have become complacent with its investors' money. If management fees have fallen out of line with the resource required, then so too has the performance element of remuneration. Carried interest, as the 20 per cent share of a fund's profits is known, is only skimmed off the top once a hurdle of around 8 per cent has been cleared in returns to investors. The hurdle rate reflects the historic return investors could expect from the quoted market. The managers could only pay themselves once they had out-performed the markets, the reason for investing in alternative assets in the first place. Rosenberg admits it is looking different today but, until the recent slowdown, shrewd stockpicking in the public markets would also have cleared an 8 per cent return.

Scott, Scollan, Vercoutère and Rosenberg are united in what should be the main driver behind remuneration. Scollan says: ?If they don't deliver they don't get the performance fee. I do not find that element hard to bear.?

Vercoutère says: ?It is about the alignment of interest. They can make a lot of money as long as we do. What is troublesome is when the general partner makes a lot of money at the expense of the limited partners.? Rosenberg's fear for some of the limited partners invested in US funds is the extreme fracture of interests.

Renegotiating the dirty bits
To be sure, there have been some improvements. Until relatively recently only the profits on winners were aggregated. Each investment was its own partnership, and the failures were carried by the investors in the deal. Transaction fees, a 1 per cent fillip on the side of a deal, used to go to the partnership, but the limited partners' share was capped. Today these fees, which Rosenberg calls the dirty bits, are open for negotiation. Scollan says: ?Transaction fees, directors' fees, we look at how they are shared out. If they go towards paying abort costs for abandoning a transaction, then that's good. At the end of the day we are trying to get an equitable share of the goodies.?

Very few begrudge the private equity industry its higher fees. Private equity executives cannot sell an underperforming asset like a quoted equity manager does. They have to turn it round. That costs and in the years to come it is not going to become any cheaper. Ian Armitage, chief executive of HgCapital, says buyout firms will have to take on some of the characteristics of venture capital firms as they roll up their sleeves to help their portfolio companies through the downturn. Increasingly, according to Scollan, investors will look beyond the performance and consider how the performance was actually produced. She says: ?A hike in the p/e ratios does not give us much comfort. We are looking for sustainable performance.? And if Morley does not see sustainable performance it will not pay for it.

The management fee should not be a profit centre.

All told, general partners are ill-served if they forget who writes the cheque. The last word to Vercoutère: ?This is a private market and a negotiation between two partners. No two funds have the same investors and no two the same terms and conditions. It is a balance of power, so when the money is tight the supply side has more leverage.?

Over at Bear Market the race is still on. Horses and jockeys are nervous and the owners cannot bank on any sure fire winners. Place your bets, limited partners, but do make sure you get the very best odds.

Nicholas Lockley is private equity correspondent of Financial News.