Two years on from the US regulator firing a warning shot across the bows of the $3.5 trillion private equity industry, things are beginning to change. The Securities and Exchange Commission’s important “sunshine speech” demanded more transparency around fee reporting in the opaque and controversial asset class, describing many of the industry contracts as a grey area that allowed managers to charge investors and pension funds hidden and backdoor fees. Private equity has always been one of the most expensive asset classes for investors, but faced with new pressure for free transparency from beneficiaries and trustees, and needing to slash costs in the tough investment climate, pension funds are following the regulator’s lead with their own initiatives to increase transparency in a sector that’s been shrouded in secrecy for years.
Landmark progress includes the influential $280 billion California Public Employees’ Retirement System, Calpers, unprecedented revelation that it paid $3.4 billion in performance fees to private equity managers over the past 25 years. Most funds have avoided disclosing payouts because accounting rules haven’t demand it, and high returns have mitigated cost concerns. In another development, the Institutional Limited Partners Association, ILPA, a global trade organisation representing some 300 institutional investors in private equity, has drawn up the first ever standard fee reporting template for the industry in direct response to its members’ demands. Developed in consultation with investors but also managers and advisors, the template simplifies how fund managers’ report fees to investors. ILPA members invest around $1 trillion with private equity managers, yet pension funds have been slow to demand clarity on fees for reasons that range from ignorance at how large or extensive they have become to a reluctance to challenge managers that provide some of the best returns available, and where requests for information could affect their access to the best funds. Now investors need private equity to start behaving more like the mature asset class it has become.
“If you look back over 15 years, private equity was a much smaller industry accounting for a much smaller part of investors’ balance sheets,” explains Anders Strömblad, an ILPA board member and head of external management at the $35 billion Swedish buffer fund AP2, which has a 5 per cent allocation to private equity via some 80 funds in Europe, North America and Asia. “As private equity has delivered good returns, so is it growing as an asset class. What we are now seeing around fee transparency is a natural development and sign of the industry maturing.”
Most private equity funds are organised as limited partnerships with managers serving as general partners, GPs, and institutional investors providing the capital as limited partners, LPs. GPs typically charge LPs a 2 per cent annual management fee and take 20 per cent performance fees, gains known in the industry as “carried interest,” for which there is no industry standard or uniformity. Like performance fees, monitoring fees are another bugbear. These consultancy fees are paid by the portfolio companies to the GP and can last for as long as a decade. In an effort to recover what would be lost revenue, GPs levy a lump-sum fee ahead of a sale, or when they take a portfolio company public, slashing the value of the portfolio company to the detriment of investors. It’s a practice for which Blackstone, the world’s biggest private equity manager with $300 billion funds under management and which invested a record $32 billion in private equity in 2015, picked up a $39 million fine from the SEC last year.
ILPA’s template will require GPs flag these fees but also capture expenses and the incentive allocation paid to managers and their affiliates. As the chief executive of ILPA, Peter Freire, explains, investors will be able to compare fund performance going back to inception, plus a whole range of advisory, placement and deal fees. “In particular, this data will support LPs’ internal allocation decisions, help steer their manager selection processes – both for new managers and for re-ups – and will feed up into top line organisational assessments of value across the portfolio.”
It is the kind of transparency investors hope will help them to both negotiate better deals and level the playing field which currently lets the biggest LPs, with the best relationships, also get the best deals. “I think the larger investors tend to get what they want,” says Henrik Nøhr Poulsen, chief investment officer, equities and alternatives at Denmark’s PFA, growing its allocation to private equity in an alternative asset allocation that will reach 10 per cent of its DKK550 billion ($82.1 billion) assets under management. Yet even the biggest and most seasoned LPs believe the pendulum has swung in GPs favour as competition for the best deals soars with declining returns in public markets. Oregon State Treasury, which runs $90 billion worth of state investments including the $70 billion Oregon Public Employees Retirement Fund, was one of the first pension funds in the US to invest in private equity back in 1981, but chief investment officer John Skjervem says GPs now have all the power. “In private markets Oregon has historically held a competitive advantage due to commitment size and reputation. But now good GPs enjoy all the market power as most LPs have raised their PE allocations, creating heightened demand for and often well oversubscribed commitments to the top funds,” says Skjervem.
For other funds it is difficult to cut costs when private equity fees remain so baffling. “We have done a lot of work across our portfolio to make sure that we understand our costs. The fees we pay are now 35 per cent lower than they were four years ago as a percentage of our assets under management, but when it comes to private equity, it has involved a lot of work and the information that comes back is not easily comparable,” said James Duberly, director, pensions investments at the UK’s £12.5 billion ($18.8 billion) BBC Pension Trust with a 5 per cent allocation to private equity. Fee disclosure via the ILPA template may be a condition of investment going forward, he says. “At this stage we are talking to all our managers to see what comes back but I can see a scenario whereby filling in this type of form becomes a condition of us hiring a manager.”
And, of course, transparency will see investors negotiate better terms. “Disclosure will mean investors will be able to put pressure on fees where pressure can be applied. Although it will depend on the manager, I think it will give LPs more negotiating power,” says Geoffrey Geiger, head of private equity at the £49 billion University Superannuation Scheme, the UK’s pension fund for university and higher education staff. Ludovic Phalippou, finance professor at the University of Oxford Saïd Business School believes disclosure will lead to LPs avoiding GPs with more aggressive fee structures altogether. “Our data shows that investors are rewarding GPs that don’t charge hidden fees.” Transparency around fees could also act as a catalyst to streamline and improve the industry in other areas, like the introduction of standardised contracts, something AP2’s Strömblad wants. “LP and GP contracts vary a lot in the industry, often around different wording because of different legal advisors. This could also become more uniform as the industry matures,” he says.
ILPA is convinced its template is in GPs favour too. GPs, many of whom have remained noticeably quiet as the fee debate has raged, have broken their silence in support of the template with 25 endorsing it, including industry giants like Carlyle Group, with $188 billion of assets under management across 126 funds and 160 fund of funds. The idea is that standardisation will reduce the compliance burden of running a wide variety of bespoke template formats for different LPs. And better disclosure will ultimately benefit the industry as more money flows into private equity. Over the past decade, private-equity investments out-earned all other pension-fund holdings with an annualised 11.9 per cent compared with 7.7 per cent for real estate and 7.1 per cent for stocks, according to the Wilshire Trust Universe Comparison Service. Yet secrecy around fees alarms investors to the extent that they haven’t allocated as much to the asset class as they could have. “Fee transparency will help solve one of trustees and stakeholders biggest qualms about the asset class,” says the BBCs’ Duberly.
Which leads to the next challenge: making sure disclosure improves given that using the template is voluntary. “The responsibility for determining how the template can be used to support their needs lies with individual LPs and their managers,” explains Freire, who insists it is already taking root due to investor pressure. “LPs are in direct dialogue with managers to request that they use the template and managers are responding positively to those requests.” But the lack of coercion is a source of concern for Eileen Appelbaum, senior economist at the Washington-based Center for Economic and Policy Research, who believes only regulation will sort the problem out, as private equity firms won’t voluntarily open the door to the prospect of lower fees. “I applaud the ILPA but it is unlikely that LPs will be able to force GPs to do anything they don’t want to. For whatever reason, private equity firms have the upper hand.”
As investors demand more transparency from GPs, so they have begun the slow – and painful – process of totalling their own private equity bills in response to pressure from trustees and lawmakers demanding clarity on fees and the impact on returns. Calpers, for whom private equity is a top performing asset involving relationships with some 700 funds, has revealed its costs along with others in New Mexico, South Carolina, Kentuky and New Jersey. New York City Pension Funds is also on the case having written to all 117 of its private equity managers demanding that they reveal all fees and expenses – or be dropped from its portfolio. Now the spotlight is on $188 billion Calstrs with a $20.3 billion private equity program begun in 1988. But extracting historic data from managers is a challenging process and nor will many investors have a record of performance fees paid to funds that have matured. Facts that leads ILPA’s Friere to caution investors to “take a considered and thoughtful approach” to requesting information for older funds. “The operational requirements to provide it could very well exceed the value of having deep historical data,” he says.
While progress on fees drags, some funds have seized the initiative to lower costs through direct and co-investment programs in a reminder that managers don’t hold all the cards. PGGM, the €186.6 billion ($204 billion) Dutch fund which manages money on behalf of PFZW, a pension fund for Dutch nurses and social workers, has introduced its own re-numeration guidelines for all its external managers and is building an in-house team to invest in companies directly. “These kind of co-investments are becoming more important because they are a means to cut costs and exert control. We expect to do 10 co-investments this year,” said Maurice Wilbrink, a PGGM spokesman. In another development, PGGM also bought a stake in a new private equity firm Nordian Capital Partners in exchange for better terms on fees. USS is pursuing a similar strategy. “Like turning an oil tanker, it takes time to adjust the mix but we are aiming to increase the relative proportion of directs over time whilst remaining a significant fund investor,” says Geiger.
Fee disclosure won’t happen overnight and larger, developed funds with sophisticated systems will find it easier to introduce the template than smaller funds. But things are changing as private equity tries to come up with a self-regulatory response before the SEC gets really involved.