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Friday Letter: A question of size

LPs are tired of fees on undrawn capital commitments. A wholesale switch to managers charging for invested capital only may be an answer but it's not the solution.

 

‘Nice work if you can get it’ is a label that can be readily applied to private equity – not least because of how lucrative it is for its practitioners. This week the economics of the asset class has once again come into focus, and in particular the still near-universal practice amongst fund managers of charging management fees on capital raised but not yet invested. 

Understandably, most investors don’t like the practice very much. It intensifies the J-curve effect and makes true alignment between LPs and GPs more difficult to maintain.

For those who are demanding change, the question to consider is whether a wholesale shift to fees payable on money-in-the-ground-only would be a sensible way forward for everyone.

We think not. To advocate reform on a one-size-fits-all basis is to ignore the fact that when it comes to funding a viable investment platform, a large firm with many billions under management and multiple income streams flowing from them is one thing, and a younger, leaner, more modestly capitalised outfit quite another. For the latter type, the ability to charge on committed capital is likely going to be a necessity. Its absence would make it more difficult to pay for the resources and infrastructure that good investing requires. It may also create an incentive for managers to draw down capital quickly even when a more patient approach to deal-making might have delivered better outcomes.

The big houses on the other hand, by dint of having achieved the success that allowed them to get big in the first place, do not have this problem. For them, the conventional structure means management fees are often a source of considerable profit, which can be used to grow the partners’ wealth, support the share price, or indeed both.

LPs who continue to think that both types of manager have a role to play in their portfolios will need to be mindful of these differences. Activist types will do well to devote their energy to trying to rewrite the terms of trade with the larger groups, rather than inadvertently depriving the smaller players of their operational lifeblood.

Everything else being equal, it's also worth reminding yourself of the available evidence suggesting that fund size and performance are negatively correlated: the larger the fund – and, by extension, the firm – the less likely that 3x-or-better multiple on exit. Investors attracted to this formula will need to live with the fact, rightly, that payment for exposure to those smaller alpha-generating strategies will be due upfront.

And to those inclined to push the mega-firms on fees we say good luck: in the current environment, with demand for big brand name private equity still going strong, they will likely find the going quite tough.