It is long overdue, but big institutional investors are finally rebelling against the outsized fees charged by large private equity firms. Since the moneybags are an understated lot, their protest, so far, looks rather tame. But by the standards of this clubby world, this is still a serious move.
Originally, when funds were smaller, the typical 2% annual fee was meant to cover overheads (including staff salaries), with the performance fees (typically 20% of the upside, with no benchmarking against inflation or prevailing interest rates) meant to constitute the meaty reward. But for a $5 billion fund, the annual fees are $100 million, meaning the top dogs have a very handsome living just for showing up in the morning. That’s before the fact that they also charge transaction fees (only a portion of which is plowed back into the fund) and sometimes “consulting” fees to portfolio companies.And the outsized comp for PE firms and hedge funds serves to justify high pay levels for Wall Street firms (the threat being that the “talent” will decamp for these greener pastures if they don’t get their way).
Although investors have been unhappy about fees for some time, this salvo shows a new level of seriousness. Predictably, however, the Wall Street Journal spins the story in favor of the industry, starting with the headline, “Investor Principles Rankle Buyout Shops“:
Having played nice for years, private-equity firms and their investors—pension funds, endowments and foundations—are exchanging punches over the terms and fees paid to buyout shops… the Institutional Limited Partners Association, calls for big changes in the hidebound ways of private equity. The principles, which call for suggested caps on fees, increased disclosure, and greater investor oversight, have rankled some buyout executives. Some have complained that the investors are illegally conspiring against them. ILPA denies it.
The investor group has outsize influence, with 215 members controlling more than $1 trillion in private-equity assets. The principles are a rare show of strength among limited partners, who have historically caved to demands of private-equity firms. Though the terms aren’t binding, ILPA hopes the “wish list” of fund terms will level the playing field…
at least three large private-equity firms have retained outside counsel to examine potential antitrust issues. A spokeswoman for law firm Boies, Schiller & Flexner LLP said that a large private-equity client has hired it to examine the issue.
Yves here. David Boies is America’s top anti trust litigator (first the never-ending IBM suit, then acting for the Department of Justice on the Microsoft), but this is ridiculous. The big PE firms engage in what amounts to cartel pricing, and they are going to hire a fancy attorney to rough up their biggest meal tickets? Yet another example of industry sociopathy in action. Back to the article, which spills more ink dignifying this idea than it deserves before noting:
Kathy Jeramaz-Larson, executive director of the Toronto-based ILPA, says the organization’s lawyers have vetted the principles and there are no antitrust issues. She points out that there aren’t any specific terms in any of the documentation…
One of the more contentious issues relates to fees. The principles state that management fees “should cover normal operating costs for the firm and its principals and should not be excessive.”
Also, the principles suggest that all additional fees charged—such as so-called deal fees that firms pay themselves for completing a transaction—should accrue solely to the investors rather than split between the investors and the private-equity firm…
“The firms shouldn’t use management fees as profit centers,” Ms. Jeramaz-Larson said. “We want them to make their money off of the carry,” a reference to the 20% of a fund’s profits that private-equity firms normally charge.
Some changes already are afoot. For instance, Blackstone Group LP has cut it fees on a new fund planning to invest in infrastructure deals, reducing the carried interest—the percentage of profits paid out to the firm—to 10% from 15%. Goldman Sachs Group Inc. made a similar move with its latest infrastructure fund, reducing the so-called carry from 20% to 10%.
Buyout executives acknowledge that there even if there are legal problems with ILPA members’ conduct, there is likely to be little sympathy for the plight of private-equity firms.
“Even if there was an antitrust problem from a legal perspective,” said one senior private-equity executive at a large firm, “I don’t see the Justice Department coming to the rescue of Henry Kravis and Stephen Schwarzman.”
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Sorry if this is a dumb question, but could you please explain why it took so long for all that money to rebel on the fees?
I’m just trying to understand the timing, that’s all.
Also, does the new “get tough” line mean that institutional investors are going to start getting tough on executive compensation in the stocks they own as well?
It’s not a dumb question, and I honestly do not know why it has taken so long. This is overdue by at least a decade. Private equity returns are basically levered equity with more fees attached. The short answer is that PE is treated as a separate asset class (an idea I find dubious, it shows lower volatility due to less frequent/realistic marking, and a big propensity not to recognize reduction in value till required, as was revealed big time in 2008, when a lot of fund kept the valuations at indefensibly high levels). So according to Big Investor Orthodoxy, you have to put some money in PE, and if you are a really big investor, there aren’t that many big funds out there that can absorb meaningful amounts of your money.
It is very costly and difficult to discipline public companies. A group of Goldman’s big investors had a stern talk with the firm re their unhappiness with its pay policies. They ignored them. It is very hard to replace directors, etc. This is a huge principal/agent problem.
Yves,
As with politicians/lobbyists, don’t you think incestuous relationships and the neverending revolving door play a role here?
Every pension plan portfolio manager/”trustee” (hah!) with decisionmaking authority in the hundreds of millions or billions is galled by the public salary caps they face – quite sure of their own genius, they *know* they are worth much, much more than they actually get paid.
Enter the bespoke suited investment banker/PE sales rep oozing collegiality, the understood promise of mutual backscratching in the indeterminate future (“We’re always looking for talented personnel, such as yourself…”), and a well-manicured fistful of kickbacks both large and small (expensive trips, seminars in exotic locales, limos, etc).
So we’re not talking about LP decisionmakers here who treat the money they invest as their own.
Quite, quite the opposite.
They are extremely capable of being lazy, stupid, and corrupt.
As immediate history has shown.
And the system (sadly) has extremely attenuated mechanisms for real accountability because ultimately someone *else* is always really on the hook.
To wit,
The 20% of society that are government “workers” (having sold their political support to the Elected Class that assures them of defined benefit and other patronage) knows that they can always bleed the taxpayers for their “guaranteed” pension “rights” – even if pension plan returns are in fact pension plan losses.
So they are sloppy/lazy about policing their fund trustees/portfolio managers.
Who are equally sloppy/lazy/co-opted about policing general fund partners, investment bankers, etc.
So insane deals get done, with insane terms, and insane transaction fees.
And predictable, long-term outcomes.
The only honest and unprotected party in this Great Chain of Bullshit – the taxpayer.
Who appropriately loathes all of the preceding.
I saw yesterday where Ford’s president knocked down $17.9 million last year.
Ancient wisdom says there are good times and bad times—-seven good years and seven bad years. But these guys seem to have devised strategies whereby they are immune to any ups and downs. Win or lose, rain or shine, they still take home their huge pay packages.
Much as I usually shy away from cultural explanations, I think they’re appropriate here. For example CEO’s in other countries make far less than American CEO’s (as a factor of average worker pay) and the Germans get up in arms about bankers compensation even close to what they (perhaps justifiably) call the Anglo-Saxon model. Is there anyone who’ll argue that American CEO’s are so much better than say, Canadian CEO’s, or that Canadian CEO’s are horribly underpaid?
I’m always reminded of aristocracy in the middle ages and the centuries immediately thereafter. Did people come to see the large share of their production that the nobles skimmed as somehow legitimate? At least in the feudal era the lord of the manor granted protection in exchange. But what about later, when countries had greater internal stability and the serfs were freed. How many people just accepted, at least to some extent, the legitimacy of the remaining aristocratic privileges? Even if the peasants didn’t, how large a role did the aristocracy’s belief in their own “rights” perpetuate the situation? I suspect that people will fight harder and more effectively for what they perceive as legitimate privilege than they will for what they themselves see as unjustified privilege.
The perception of legitimacy, even if begrudging, is I suspect an important part of the power relationships in any society.
“…the top dogs have a very handsome living just for showing up in the morning.”
Well, they went to Harvard, Yale and Princeton so gosh darn it they deserve it even their highly levered deals crater over the next few years. Besides how do you expect them to make payments on their Veyrons, vacation homes in Aspen and children’s private school tuitions????
It’s clear we need an American Caste System modeled after the one in India. This would go along way to squelching the sentimental moral handwringing that some feel obligated to trot out when the elites loot the peasants through cooperation of the peasants’ agents — the fiduciaries charged with managing the peasants’ meager piggy banks. This kind of wincing and whining is unseemly. It’s embarrasing for a Nobel disposition such as the one that I have before a few hundred whiskeys.
Better to make the agents a second level caste with the elites on top and the peasants in descending levels of depravation, culminating in the lowest caste — service employees dependent on tips and tax evasion for survival.
It’s clear that talent is not bestowed equally upon humanity. Why not just formalize that so everyone benefits? And I could use another $20 million in annual pay to help my Pyramid reach another level of incredulity. So what if a few million peasants die young, hopeless and broke? I have talent and assets and they don’t. It’s all kind of funny to me. Can’t help it if I was born lucky.
– Manlius Privil Cohereitence
Master of the Levers and Chief Steerer
U.S.S. Hindinberger, Plier of the Pliers, LLC, LLD, LBO
Anyone unfortunate enough to run into the justice system knows a criminal defense lawyer has two levels of fee: One for a defense, and one much higher for an acquittal. It sounds like the large money is paying the sure thing price and getting the iffy product.
Money management tends to make no sense for anyone but the big bags. Out here in Bitterland, the fees for 401Ks and financial advice on lifetime savings take up the majority of return in the good years and are still levied in the loss years. A little math shows a bank account gives about the same yield on investment. It’s only when there’s supposed economy of scale hiring expertise matters.
Inevitably, the financial world has insiders and outsiders. People who handle money are going to gain insight just as surely as shepherds know sheep and auto mechanics know engines. Turning that world into “our thing” and then selling admission dearly is a scam on the face of it.
Financial professionals make sense when they supply some good common sense and a bit of objectivity. Promising to let someone in on the good stuff for outrageous fees is dishonest and, apparently, doesn’t pay off.