When it come to private equity, you don’t always get what you pay for

Private Equity 27 Jul 2011

One only has to gauge the very public and very negative reaction to DVD rental and online streaming movie provider Netflix’s decision to up their prices by a fairly hefty 60% to get a sense of how people feel about paying higher fees for things.

Expectations in this day and age is that you should always get more for at least the same, and certainly not more for a lot more.

Apparently private equity investors feel the same way when it comes to fund terms and conditions. Indeed, research firm Preqin’s most recent study on the matter (click here to download) notes that management fees are still causing significant unrest amongst investors.

Used to be that investors by and large weren’t too fussed about fees. So long as an investment was generating decent after-fees returns, it didn’t really matter whether it was 2 and 20 or 3 and 30 or some other variation, as is more commonly the case in the private equity world.

No longer. Preqin’s latest report notes in fairly plain language that, like Netflix’s subscribers, they aren’t going to be doling out significantly more coin for something they don’t have a lot of say in: in private equity’s case, an alignment of interests and confidence that the fee structure will provide some partnership, camaraderie and transparency; in Netflix’s case, that it will give viewers half-decent new releases.

Specifically, the survey found that 50% of limited partners feel that there is a misalignment of interests between themselves and fund managers when it comes to management fees – i.e., the general managers of the fund don’t necessarily eat their own cooking, but do collect a pretty big chunk of cash from investors.

Further, 71% of investors are considering new general partner relationships in 2011, and just 29% will only invest with existing fund managers. What’s more, a significant number of investors believe that general partners should invest more in their own funds in order to achieve a greater alignment of interests.

“LPs are not necessarily demanding a specific management fee level; what is far more important is that the fees make sense in the context of the management of the fund,” said TK Kenyon in an accompanying release. “Our recent conversations with LPs have revealed that many will consider paying higher fees if this can be justified by higher performance, and if higher management fees are necessary to operate a superior firm effectively then many investors will see this as a price worth paying.”

Like if Netflix or some other online video streaming service offered instant live access to new-release movies. Then it might be worth paying more for.

The chart below shows the key areas where LPs feel that improvements can be made in fund terms and conditions based on detailed interviews with 50 leading institutional investors. Fund management fees remain the biggest bone of contention, with 50% of those taking part in the study highlighting this as a key problem area. GP commitments to their own vehicles are also a major issue, with carry, hurdle rates and rebates also facing scrutiny from investors.

“While we are seeing some downward movement, with the management fee during investment period for the largest funds dropping to a mean of 1.71%, the change is not as dramatic as we have seen in other areas – which does go part of the way in explaining why 50% of LPs remain dissatisfied,” notes the report.

The other factors behind the lack of real movement can also be explained by the type of funds actually succeeding in closing to outside investors. As the chart below shows, 61% of investors said they would be willing to pay higher fees for access to fund managers that they perceive to have better track records.

These investors also noted that would or have already declined to invest in a new private equity fund vehicle launched by certain managers with whom they had previously invested – a direct result of poor communication or lack of transparency during the financial crisis.

Of course, it could be argued that investors will pay higher fees as they believe the best firms to be able to put this capital to excellent use in sourcing and managing the best opportunities, but there is certainly evidence that sought-after firms can still dictate fees to investors.

To be sure, respondents said the fundraising environment is likely not going to be getting much easier in the near term, especially over the next two years as private equity managers face more difficulties opening new funds. That also means more pressure on fees as, like their hedge fund cousins, private equity managers make more concessions in an effort to get capital in the door.

“Clearly there is a need for balance between the desires and requirements of both the GP and LP, with fund terms and conditions containing an element of give and take,” the report notes.

Perhaps Netflix could learn a thing or two about the private equity industry, and the “give and take” underway to appease its audience.

Be Sociable, Share!

Leave A Reply

← Everybody Back in the Water! Deep Diving the Family Office Investment Pool The 800-pound Hedge Fund Gorilla Might Have a Monkey on its Back →