Monday, May 4, 2015

Even Experts Can’t Unearth All of Private Equity’s Fees

Even Experts Can’t Unearth All of Private Equity’s Fees

The fees charged by private equity managers are back in the news.  CEM Benchmark issued a short report calling for standardizing total cost disclosure for private equity funds.[1]  CEM’s business is about helping institutional investors get a better handle on performance, risks, and fees.  In the report, CEM explains that it is impossible to obtain a comprehensive picture of the direct and indirect fees charged by PE firms to investors.  The report also generated a column by Gretchen Morgenson in yesterday’s New York Times.[2]

As best CEM can tell, about 2% in fees go unreported on average.   That amounts to $60 million per year for your typical $3 billion private equity fund.  The private equity industry would argue that accounting for all the fees is unnecessary because all that matters is the net performance of the fund.  In other words, as long as investors get reasonable returns on their investment they shouldn’t care too much about management, monitoring, board, or other fees or carried interest.

There are three big problems with this argument.  First as CEM aptly points out (and academic research shows), fees are the major cause for the failure of active managers to add value for their clients.  While it would be nice to believe that higher fees lead to better investment performance, there is no such relationship.

Second, investment performance in private equity is largely a rough estimate until a fund is fully realized in seven to ten years time.  In the meantime, the performance of a fund is based on the estimated value of unsold portfolio companies.  As a result, the net return (minus all the fees) doesn’t really tell you whether the fund is truly worth its expenses.

Third, private equity is notoriously secretive in order to protect their profits.  PE managers only grudgingly share information with investment staff, and they abuse the public records law exemptions to keep taxpayers and beneficiaries in the dark.   Both CEM and Ms. Morgenson detail the extraordinary efforts of Treasurer Curtis Loftis and the staff of the South Carolina Retirement Investment Commission to get a handle on their PE expenses.  After several years, South Carolina still doesn’t have a comprehensive picture.

Standardized disclosure of fees isn’t going to happen any time soon.  Critics have been calling for standardized fund documents for more than ten years, and nothing has changed.  If anything, these documents have become lengthier and more obtuse.  Private equity is politically powerful and wildly profitable.  Until large institutional investors learn to say “no” to private equity, the industry will continue to hide fees.  Meanwhile, the industry is well served by obfuscation.


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