Towers Watson recently floated an alternative private equity fee model that aims to incentivise managers to outperform while cutting investors’ overall fee burden. Investment consultant Dan Simpson would like to see his clients reject two-and-20 fee structures and instead negotiate a “budgeted base fee” with managers to fund the operations of their businesses while they seek deals. This fee stream would roughly equate to 1 per cent – or less – of invested capital. And when deals are executed, transaction fees should be “done away with or at least put into the fund run by the manager,” he says.
The model features two tiers of performance fee: the first rewards managers for retaining key staff and meeting business goals such as achieving earnings growth targets in underlying companies, while the second rewards investment returns, handing 10 per cent of outperformance to the manager, payable only when the fund is wound up and ideally aligned with long-term staff incentives. The model aims to deliver more alpha to investors. But its emphasis on awarding fees based on invested capital only does not win the approval of some asset owners. Judith Smith, head of private equity at Industry Funds Management, says this arrangement could impel managers to make rushed or flawed deals just to bring fees in the door.
“I’d much rather managers felt they could wait until they had better deal opportunities than feel they had to constantly deploy,” she says. Paying fees on invested capital only could make work tough for managers who are starting out, she adds. But she agrees that transaction fees should be redirected into private equity vehicles, rather than being “collateralised” as part of the cost of doing deals. There are other daring feegrabs out there, such as certain fund-of-funds managers charging “monitoring fees” for keeping watch on managers operating overseas – a task which is presumably compensated for in the base fee. But Smith was not too fazed by expensive fees if managers could outperform and find ways to improve their capabilities.
“If the returns are demonstrated, and the manager has a team on the ground, you can get your head around the fees. “But if you get a fee, you’ve got to use it. You’ve should have people on the ground.” The $13 billion superannuation fund Cbus has sought to provide a clearer disclosure of its investment costs by asking its private equity fund-of-funds (private equity FoF) managers to reveal the fees charged by underlying strategies. Trish Donohue, executive manager of investments, says the industry fund felt it was important to do this because private-equity holdings account for 9 per cent of its total portfolio.