Private equity investors want fairer fee structures from fund managers

7th November 2011

They are threatening to put pressure on private equity bosses who charge more for less performance or who regard locked-in investors as fertile grounds for a fee increase.  These mostly offshore funds are often unregulated – in the same way as the majority of hedge funds.

According to the Financial Times, investors in private equity and buy-out funds are lobbying for a change in the "2+20" charging model where managers take 2% of the fund's assets as an annual fee plus a further 20% based on gains.

The 20% is normally subject to a "high water mark", technically known as a "loss carryforward provision".  This means the performance fee only applies gains after previous losses, if any, have been made up. This stops managers from getting paid large sums just to get back to where they started.

Investors argue that economies of scale should apply, especially to the annual fee. They contend that it is wrong to pay a manager of a £10bn fund, twice that of a £5bn fund as it is unlikely to cost double to control the larger fund.  Lower fees to reflect a larger fund are normal in UK investment trusts although not in the world of unit trusts.

They also contend that the regular annual fee – the average 2% – is paid irrespective of success, unlike the 20% management bonus. So if a fund stays static by doing nothing, it will continue to earn even if the extra based on performance is never paid out. This causes a conflict of interest between fund managers and investors.

Investors might wonder why investors have not questioned these charges before. Some funds have shaved fees over the past year but as long as funds produce good returns, investors in general have tended to turn a blind eye to costs. For some large investors, getting tough on charges is difficult as they may represent organisations which themselves benefit from high charges and fail to pass on economies of scale.

Some investors in both private equity and hedge funds see themselves as victims of a charges cartel – so they have little option if they are to continue using these asset classes. In addition, many funds are difficult to exit.

Individual investors – or even investment industry interest groups such as the Association of British Insurers – rarely have enough clout to force a change. 

However there are signs of stirring on specific funds. The Financial Times recently told how investors in European private equity group Cognetas were outraged as the group proposed a higher performance fee despite losing some investors up to a third of their money. Cognetas plans to link performance fees to its depressed asset value, ignoring the high-water mark concept which would oblige it to repay past negatives before it could start earning again.

Although this fund started off worth some €1.2bn, that's mid-sized and not major, and is now worth substantially less, investors fear it could create a precedent for other funds wanting to increase their fees, effectively giving them an open cheque on which they could write their own sums.

But other investors in the fund argue that paying more now could rescue something – the alternative might be that remaining talented managers quit, potentially leading to even bigger losses.

Hedge funds are also fans of the 2+20 model. They have been faced with revolts over similar issues, and have given investors a stark choice.

They say: " Either pay up more now and we'll try to recover the losses, incentivised by the charging structure, or we'll shut the fund down (which can be costly) and re-invest what's left into a new fund, giving us a new start for high water marks.

There are now signs that investors are at least questioning that take it or leave it choice.

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