Different Worlds.

I’ve been in asset management for more than thirty years; much of it in institutional asset management. Now, having spent the last two decades successfully buying asset managers, I find myself being regarded as part of the Private Equity sector as we progress our plans for a fund investing in minority stakes in boutique asset management firms. 

The transition to PE has been eye opening. Two contrasting stories from my past serve to illustrate this.

Some years ago, I was asked to urgently fly to Asia to deal with an institution who was threatening to sack one of our firms as manager of a large equity mandate. Our ‘crime’? The client had reviewed their trading costs and found out that our firm was a basis point more expensive than their average manager. I flew, apologised, and agreed to review our trading costs accordingly. We were performing well but that extra one hundredth of a percent almost got us fired. 

Fast forward a decade, and we had just acquired another manager and I spoke to the firm’s CEO to discuss our first board and a dinner to enable our board and wider team to meet their counterparts in the newly acquired business. He seemed strangely reluctant and when I asked him about this he said “Ok, but let’s not go crazy on the numbers travelling”. I asked why he was concerned about our wider team coming to meet his people and he responded that under a previous PE ownership the new owners had attended a similar event, for which he later received a six-figure invoice for private jet travel and 5-star accommodation costs for everyone attending!

I assured him that we didn’t use a private jet and, in our view, the costs of getting to know our businesses better was a cost we should bear – not our investors. 

I’ve subsequently mentioned the story to a number of those who are involved in the PE sector and the response has normally sparked a whole new range of anecdotes about the excesses of the sector in terms of fees, recharges, or allocations of expenses. 

It’s hard to verify everything you hear and some of it may be past rather than current practice, but the scale, volume and frequency of these stories is just too great to ignore. Even the FCA and the SEC have recently added their warnings to those of larger investors and industry groups who have found opaque high fees, conflicts of interest and poor practices amongst PE sponsors. 

Stories abound of offsites and training sessions charged to funds; travel, entertaining and marketing costs routinely expensed, and even evidence of ‘in-house’ affiliates being recharged as if they were arm’s length suppliers. 

These costs are at best opaque and, at worst, actively hidden, but even the disclosed fees can be astonishing. We believe that an 8% gross hurdle rate is appropriate for a private fund investing in our sector. We felt that was reasonable and have reflected that in our plans, but we are often asked what our ‘catch-up’ rate is planned to be? For those of you that are unfamiliar with the concept, ‘catch-up’ is how a hurdle really ceases to be a hurdle. We feel that an 8% return before basic fees belongs to the client. We think the manager should only get carry on anything above that. 

However, in a catch-up scenario, if the fund’s return is materially above the hurdle, the sponsor is entitled to effectively clawback part of the return between 0% and the hurdle so they get paid carry on the whole return – not just that in excess of the hurdle. 

We struggle to understand how this is justified. We cannot see how a fund’s investment manager is due an extra payment on a return between 0% and 8% – no matter what the total outcome. A return between 0% and 8% is hardly justified for a fund which may have total base costs of 2%  or more. If you’re investing in private markets 8% is hardly an outsized return – the client should at least expect a clear gross return of 8% shouldn’t they? The timing may be flattering, but we are currently in a world where the S&P 500 has returned over 12% pa.* Taking a base fee and 15 or 20% on returns below 8% in an illiquid investment is rich to say the least. 

You’re probably wondering how my two earlier anecdotes relate to these observations on Private Equity costs, charging structures and conflicts? Well, that the same client who I flew out to appease over the one basis point cost disadvantage is also a substantial investor in PE funds – some of which will charge total fees of 2 or 3% and are subject to the same layers of fees costs and conflicts of interest. It’s a stark contrast that a basis point can get you fired in one part of the money management sector while charging 3% or more is ‘normal’ elsewhere. The returns aren’t really all that different – surely this is a situation which cannot continue? 

*Ten years to 31 December 2020, dividends reinvested.