At Private Equity’s Davos, Firms Plan to Rip Up the Rule Book on Fees

March 02, 2015 by Loch Adamson

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The Carlyle Group's David Rubenstein delivers the keynote address at the 2014 SuperReturn conference in Berlin. (Credit: SuperReturn)

The brand name speakers at an industry conference see big changes ahead for payment models in private equity. Is the management fee on its way out?

The annual SuperReturn International conference is Davos for the private equity set. This year, the heavy-hitters gathered in Berlin’s Intercontinental Hotel, and not just to talk about fundraising, deal flow or leverage. This year, the hot topic was change — in the funds they manage and the fees they charge.

During the conference, we heard no less than three different visions of how the industry is undergoing radical transformation. Each of three key speakers pointed to the diminishing role of private equity funds in their future — and by implication, at least, of the management fees they generate.

First was Jim Coulter, co-founder of Fort Worth, Texas–based TPG Capital, which counts Singapore’s GIC and the Kuwait Investment Authority among its shareholders. "I’ve never seen a period of time when we’ve had the extent of titanic shifts in the industry that we are seeing right now," Coulter told the audience at SuperReturn, "the first is really the shift from funds."

TPG declined Sovereign Wealth Center’s request for an interview to explain Coulter’s comments further — but co-investment as a substitute for fund allocations is becoming an increasingly prevalent trend in the business, as institutions like sovereign wealth funds seek greater transparency and influence over the investments made my managers on their behalf.

The second kingpin to underscore institutional investors’ desire for great accountability from their managers was Guy Hands, chairman and CIO of London-based Terra Firma Capital Partners. On February 9, 2015, Terra Firma announced that it had €1 billion of its own money to deploy in new deals alongside co-investors.

The week before SuperReturn, Hands spoke to Sovereign Wealth Center about his new investment model, which he said was prompted first by three factors: client demand, missed opportunities as it scrambled to raise money for a new renewable energy fund, and Terra Firma’s own available and abundant capital. You can read more about Hands’ new model here.

Warren Buffett

Finally, Joseph Baratta, head of private equity at New York-based Blackstone Group said the firm is talking to its biggest investors about creating a "coalition of the willing" that can buy control of large companies outside its existing funds. Blackstone, which counts the China Investment Corp. as one of its largest shareholders, wants to be able hold bigger stakes in companies for longer timeframes than allowed by the standard 7–10 year duration of a fund.

Baratta likened the approach to that of Berkshire Hathaway CEO Warren Buffett. "I don’t know why Warren Buffett should be the only person who can have a 15–year, 14 percent sort of return horizon," he said. A Blackstone spokesman declined to comment on Baratta’s statements.

Not everybody sees titanic, or even Titanic developments unfolding. While TPG, Terra Firma and Blackstone see big changes ahead, co-CEO David Rubenstein of Washington, D.C.–based Carlyle Group is more circumspect. On February 11, Rubenstein said on an earnings conference call that the fund business was healthy, and benefiting from state-owned investor investments."We have seen is that the large sovereign wealth funds are now coming in to the market in very large sizes and making very, very large commitments, much more than we’ve ever seen before," he said.

At SuperReturn Rubenstein focused on increasing transparency and accountability in the industry, rather than talking about fundamental overhaul of how the business works. "People will actually know what a top quartile fund is," he said, referring to the natural outcome of such developments. He foresees formal structures of some sort to gauge such performance. "There will be a standard definition and a standard organization — government or nongovernment — that will certify someone is a top quartile. People will not be able to say they are top quartile, when they are not."

Carried Interest

Rubinstein's focus may speak to the glut of institutional investor money flowing into his firm. Investors new to the sector are cautious and are choosing what Hands calls "me-too funds," managed by reputable, established firms, like Carlyle, that have long track records and make investors feel confident they will get solid annual returns of 8 to 10 percent on average after fees.

Hands says these types of funds will continue to have a place in the industry, although a diminishing one. He forecasts their share of the market will shrink to 50 percent, as more experienced institutional investors, such as GIC or the Abu Dhabi Investment Authority, seek different kinds of investments and higher returns from what Hands calls "more entrepreneurial fund managers and more entrepreneurial deals".

Some sovereign wealth funds concur, including CEO David Neal of Australia’s Future Fund. "Across our portfolio we’re looking for the best ideas and opportunities in private equity," he says. The best opportunities, he says, are in later stage venture capital, where the managers are generally more entrepreneurial.

Fee Levels

Even if Carlyle is on a roll, other private equity firms — like Blackstone and TPG — are responding to their client demand for a new way to invest in unlisted companies. Since the 2008–’09 financial crisis, sovereign wealth funds and other big institutions have been pushing back on the traditional two-and-twenty fee structure, in which the manager charges two percent of capital committed l to the fund for ongoing management and takes 20 percent of the profits.

The new models cited at SuperReturn are largely a result of growing investor suspicion that management fees incentivize firms to expand assets rather than generating big profits for investors. Institutions particularly dislike management fees that are charged on committed, not invested, capital. Hands says sovereign wealth funds and other institutions are willing to pay the so-called carried interest — the performance fee of 20 percent of profit on a deal — since the interests of investor and manager are aligned.

Again, the Future Fund’s Neal agrees. "Alignment is just as important as the level of fees," he says. "The way fees are structured and the way they incentivize managers to work for you, not them, is just as important as how much you pay."

Some larger private equity firms may escape these pressures because they’re providing solid, if unspectacular, market returns. But the more innovative private equity managers will seek to serve their clients better, making sure their interests dovetail in the fast-changing industry.


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