To say that the issue of fees and expenses has risen up the agenda for alternative assets over the last decade would be something of an understatement. That is particularly the case for investors in limited partnerships, the staple vehicle type for many of the alternative asset classes.
Bolstered by a crackdown that has seen the Securities and Exchange Commission get tough on violations, investors in these vehicles, also known as limited partners, have pushed for greater transparency. This has forced the managers of the vehicles, or general partners, to change their limited partnership agreements to provide more details of fees and expenses.
That’s something that comes through clearly in sister publication pfm’s 2018 Fees and Expenses Benchmarking Survey. According to the survey, 38 percent of general partners revise their limited partnership agreements following a visit by the SEC and 40 percent change their valuation policies.
“A lot more funds are altering their LPAs and creating a more detailed procedure for fee and expense allocations,” says Tom Angell, a partner at WithumSmith+Brown. “They’ve become a lot more transparent and detailed.”
There is more clarity on operating partners, board and directors fees and some fees – monitoring fees, for example – have “disappeared altogether” says Angell, following action by the SEC.
pfm has conducted the Fees and Expenses Benchmarking Survey every two years since 2014. The 2018 version is the most comprehensive ever: “LPAs are getting longer and so is the survey,” says Julie Corelli, a partner at law firm Pepper Hamilton, who has been involved with the research since its inception. “Everything is becoming more granular.”
To conduct the survey, pfm contacted chief financial officers and industry professionals across the US and asked about their fees and expenses policies. The poll comes against the backdrop of a push by the SEC for increased disclosure of fees and expenses over the last four years, with enforcement actions against some of the largest private markets firms.
Apollo Global Management, one manager which runs a real estate business, had to fork out $52.8 million to resolve charges over inadequate disclosures, and other matters. Blackstone, the sector’s current champion manager, had similar issues over monitoring fees and had to pay $32.9 million. Both firms paid the fines, but neither admitted any wrongdoing. “The enforcement actions forced firms to create fees and expenses policies that are transparent and detailed to LPs,” says Angell.
The result has been something of a sea change in the way the private equity industry deals with the issue of fees and expenses: “It wasn’t well documented, it wasn’t well executed and it opened everyone up to regulatory scrutiny and investor paranoia,” says Anne Anquillare, the CEO of fund administration firm PEF Services, who has also been involved with the survey since the start. “The industry really has shifted towards transparency.”
One of the biggest areas of controversy is whether the fund should pay the expenses when a deal doesn’t complete. This year’s survey took a deeper dive into the issue than in previous years and found a 5 percent drop in the percentage of firms that charge all broken deal expenses to the fund, and a 5 percent increase in cases where all the broken deal proceeds go to the fund: a result that is “clearly favorable to LPs”, says Corelli.
Another new topic for the 2018 survey was fund restructuring. More than half the funds were found to adopt what Angell terms a “we’ll-cross-that-bridge-when-we-get-to-it approach” by saying they plan to negotiate the handling of fees and expenses at the time of the extension: a “wait-and-see approach” that “can be dangerous,” he says.
Co-investments are another area where broken deal expenses are contentious. Here there are clear signs that co-investors are being expected to pick up a growing share of the fees and expenses burden, with 9 percent more funds (40 percent in 2018 versus 31 percent in 2016) reporting that they will require a co-investment entity to bear a potion of broken deal expenses.
There is widespread agreement among everyone that pfm interviewed for the 2018 survey that there has been a fundamental shift in the fees and expenses dynamic between LPs and GPs over the last decade. “LPs expecting transparency want to know exactly what is to be charged to them so they’ve insisted on everything being detailed in the LPA,” says Corelli. “That is fundamentally not an issue and it’s a better practice to list even more than the manager expects to charge – leaves room for judgment, which is necessary to be able to do the right thing.”
Fund documents have become more “expansive,” says Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association. But while it is encouraged by the greater disclosure, the group voices concern that “burying investors in pre-emptive disclosures” can leave investors scratching their heads as to which fees they will actually end up paying. This is particularly the case when the documents give the fund manager the discretion to choose whether to levy those charges.
And the result can be heated discussions during fund negotiations over fees and expenses. “I think that counsel who represent LPs are taking a harder line,” says Corelli, who recounts an LP objecting to travel expenses as part of deal origination costs: “I said ‘So you want the portfolio manager to be incentivized to assess management over the phone? I could never recommend that the fund manager bear travel expenses incurred in the course of evaluating a specific opportunity. That’s nonsensical.”
The other big change since our first survey in 2014 is the introduction of the Institutional Limited Partners Association fee-reporting template. The 2018 survey found that 76 percent of investors either use it or are moving closer to an ILPA-standardized template, up from 68 percent in 2016.
That’s not quite as much movement as the group was expecting, says Choi, but that may be because smaller fund managers with less than $500 million in assets made up more than 40 percent of the sample, she says. Larger managers are more likely to use the ILPA template.
So what does the survey say about the state of the manager-investor dynamic, particularly where limited partnerships are concerned? Despite the increase in disclosure, “the pendulum is still so much in the GPs’ favor,” says Anquillare. “I think it’s because we haven’t had a correction in the overall marketplace for so long. There are so many institutional dollars looking for a home in private equity they just need to find yield somehow.”
But that could all change: “If they are not today positioned to be seen as balanced, fair and reasonably LP-friendly in the next cycle, it could really pose a significant challenge to raising their next fund because LPs will be understandably selective in how they place their bets if there is another turn of the cycle,” says Choi.
What is the pfm 2018 Fees and Expenses Benchmarking Survey?
The survey was launched in 2014 in response to fund managers’ questions about who should pay for various fees and expenses. The resulting report, which we produce every two years, is intended to be used as a benchmark to compare and review fee-related practices across the industry.
How was the benchmark created?
PEI’s Research & Analytics team surveyed 157 US alternatives fund managers on their fee practices in June and July 2018. We targeted CFOs because they are the most informed of these practices. However, if the CFOs were unavailable, we asked responses from other professionals, including CCOs, IR professionals, and COOs, provided they were aware of the firms’ practices. Next, this is a benchmark covering the US, so we surveyed firms from every region across the country.
More than half of all responses came from the north-east; this is reflective of the market due to the private equity hubs of New York, Washington DC, and Boston.
What about confidentiality?
The survey is entirely confidential. No names of the individuals or the firms that responded are revealed.
Why alternatives and not just private equity?
The emphasis is on private equity firms, but other alternatives, such as mezzanine debt, real estate and infrastructure, have been included. In the case of mezzanine, one can argue that the strategy qualifies as private equity due to the equity options of its investments. Meanwhile, we included real estate and infrastructure because several of these private equity firms manage diversified platforms, and, more importantly, much of the scrutiny facing private equity firms is equally placed on other alternative classes that we cover.
For additional articles, go to Fees & Expenses Survey 2018 .