Wednesday, January 25, 2012

Private Equity Fees


There's been much talk about Private Equity recently.   Yesterday, an article in the FT (behind paywall) talked about the fee structure underlying typical PE funds.  The article was based on recent research done by researchers at Yale and Maastricht Universities.

A few findings in the article and my thoughts:
1. Most PE funds are on a 2/20 basis.  2% annual fee plus 20% of any fund gains.   Compared this to your typical Vanguard fund which probably has an annual expense ratio of about 0.21%.

2. The 2% fee is based on committed capital, not invested capital.  This means that if a pension fund commits, say $100 million to a PE fund, but only ponies up $10 in the first year, the first year fee is 2% of the $100 million - or $2 million.  So in the first year, the pension fund could actually be paying a 20% fee on invested capital.  Furthermore, the 2% fee is on the total amount before the manager also takes 20% of the profits.

3. While PE was very profitable in the early years (pre 2000), in the past decade, the average PE fund made 4.5% per year after fees.  This number is also questionable because of the way that most managers compute returns.  If returns are computed on a time-weighted basis, then early returns from a PE fund are likely to be based on smaller investments.  These early returns are also likely to be higher than later returns.  As a result, I'd speculate that the actual dollar weighted returns are lower, not higher than 4.5%.

4. In the past decade, the average pension fund paid 4% a year in PE fees.  According to one of the researchers, about 70% of the investment gains have been paid in fees over the past 10 years.

So who invests in PE?  Well, just about everyone.  Most state pension funds have loads of private equity, as do most university endowments (including the university that I work for).  And these fees are just the beginning.  Frequently private equity is managed as a "Fund of Funds" which charges an additional fee to manage the portfolio of PE funds.  Add to that the overall cost of picking the "Fund of Funds" managers and the result is a huge amount of pension and endowment wealth is being squandered on fees related to PE.

Aside from fees, PE has some other very troubling properties.  First of all it is very illiquid - it is difficult to divest PE.  Second, the risk in PE is chronically understated because there is not market based evidence on how much the portfolio is worth.  The normal practice is for the PE fund manager to assign a value every quarter.  This means that the year to year fluctuation in value in PE is massively understated because of the smoothing effect of the manager's self reporting.  As my students will know, if you have a low volatility asset with a apparently high (overstated) return, a portfolio optimizer will overweight in this asset.  So the smoothing of the volatility gives the false appearance that PE is an attractive asset class.

Most state pension funds and university endowments seem to be so locked into the model that they must have PE and also hedge funds that they seem blind to these fees.  Of course, the fact that the providers of these products frequently contribute to state election campaign funds just makes the issue more troubling.

Here's my suggestion to endowments and pension funds.  Fire all your managers, experts, advisers, fund of fund pickers, tactical allocation experts and consultants and hire maybe one smart person to put together a well diversified portfolio of global index funds.   The administrative costs will be tiny, and the fund management fees will be reduced to a few basis points.  Your portfolio won't be very glamorous, but in the long run it will outperform.