Financial advisors to the wealthy view private-market investments as a way for investors to diversify and earn higher market returns than is often available in public markets.
But investors also need to consider the impact of fees on their returns when investing in the US$7 trillion market of private-equity, private-debt, and venture-capital funds. A recent analysis by London-based data and analytics firm Preqin found that the largest private-market funds are raising more in fee income as these vehicles get larger and add more layers of charges.
“A lot of investors are asking where are these fees going? What are we giving up to these private equity companies, which seem to be getting larger and larger and making more profits?” says Charlie McGrath, author of a Preqin analysis titled “Sticky private equity management fees hide the dollar cost.”
McGrath’s report was based on data from Colmore, a Preqin affiliate that tracks private-market vehicles for limited partners—the investors in these funds. Private-market fund managers are known as general partners.
For this analysis, Colmore provided Preqin with anonymous data on fund fees that they collect so they can let limited partners know whether the fees they are being charged are in line with the fund’s legal agreements, says Paul O’Shea, a senior vice president at colmore.
The clients who ask for this service tend to be larger institutional investors, such as pension funds and insurers, which typically invest in funds of at least US$1 billion or more.
The American Investment Council, a private-equity trade group, counters that the sector plays a central role in the economy, and that the returns earned by this asset class justify the fees. California Public Employees’ Retirement System, or CalPERS, invested in private-equity funds that returned almost 40% last year, the investment council said in a February report.
“Private equity invested a record amount—over US$1 trillion—across America in 2021, which helped strengthen pensions, support small businesses, and fuel the economic recovery,” a spokeswoman said in a statement. “Pensions understand that private equity is an essential part of a diversified portfolio and delivers stronger returns—net of fees—than other asset classes.”
penta recently spoke with McGrath and O’Shea about the analysis, what investors should know, and how regulators are beginning to shine a lens on private-market practices.
Rising Costs to Investors
Investors in private market funds generally pay according to what’s known as a 2-and-20 fee structure. The “2” refers to a 2% management fee charged to an investor on the dollars committed to a fund that is supposed to cover salaries, overhead, and other administrative expenses.
The “20” refers to the percentage of profits granted to the fund manager—known as the general partner—once the fund has hit an annualized performance hurdle that is typically 8%.
Management fee levels in percentage terms fell slightly to 1.68% in 2020 from 1.70% 10 years earlier, but, Preqin points out, the size of the funds has grown considerably in that time period. That means, in aggregate, the general partners of these funds are taking in more dollars as their funds grow.
For example, funds with vintage years between 2018 and 2020 had an average of US$5 billion in assets, up from an average of US$2.6 billion for funds with vintages between 2009 and 2011, the report said. In absolute-dollar terms, the newer funds collected US$88 million in annual fees compared to US$44 million in annual fees for the earlier-dated funds, Colmore found.
“The idea always was that the management fees would cover the costs, keep the lights on, and that managers should make their real money from the performance, the carry, the 20% of gains,” O’Shea says. “But they are getting rich from management fees as well.”
Also, O’Shea says, profit percentages for funds are rising to as high as 30% in the case of some venture capital funds.
New Layers of Fees
What concerns O’Shea most is the fact that a number of private-market fund managers have shifted expenses that had been covered by the management fee into a new set of fees.
A survey by the Institutional Limited Partners Association, a trade group representing private-market investors, revealed management fees at many funds didn’t cover such expenses as routine general partner administration, travel to source investments, salaries, and office overhead.
“Instead, these expenses are paid by the partnership, or fund, outside of the management fee, creating a ‘2 and 20 plus’ arrangement,” according to McGrath.
While some fund managers offset these costs with consulting income received from the companies they invest in, others have narrowed the scope of what portfolio income such as this can cover, McGrath said in his analysis.
Some funds also charge another layer of one-time fees to cover the cost of forming the fund. These fees, assessed as a percentage of each investor’s dollar commitment to the fund, may seem low in percentage terms, but they also can lead to significant overall dollar contributions as fund sizes grow, he said.
While these fees are typically capped, the caps have been rising, and some funds charge expenses outside the cap to the partnership, the report said.
Looking for More Transparency
An industry advisory body to investors called the Institutional Limited Partners Association has created a voluntary form general partners can use to break down what fees are paid and why. While useful, it’s not compulsory, and so some fund managers fill it out and others don’t, O’Shea says. Or, he says, they will fill it out for certain limited partners, but not others.
“They have the ability to do it, but they are choosing not to,” he says.
While the US Securities and Exchange Commission isn’t adopting the association’s form as a requirement, they are pushing for more disclosure by private-market funds—including hedge funds—so that regulators can better assess potential risks the funds may pose to investors and to markets. The European Securities and Market Authority is also taking a closer look at private-market funds.
On Feb. 9, the SEC proposed an amendment to existing regulations that among other things would require registered private-fund advisors “to provide investors with quarterly statements detailing certain information regarding fund fees, expenses, and performance.”In Preqin’s view, the fact funds continue to rake in ever higher management fees shows that any concerns investors have aren’t having any effect on what fees are charged. But, as McGrath points out in his analysis, “with regulators formally joining the fight, [limited partners] may see movement and clarity as they continue to allocate capital to private funds.”