Learn About Private Equity Fees

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The private equity sector has drawn a great deal of attention for its many layers of fees, especially in light of the sub par returns that it has delivered in recent years. This is sparking growing resistance from investors.

A study conducted by University academics from Yale and Maastricht for the Financial Times finds that over the 10 years starting in 2001, U.S. pension funds earned 4.5% per annum, after fees, from their private equity investments.

It compares unfavorably with the S&P 400, which produced an average annual return of 6.7% over the same period, with dividends reinvested. The study also indicates that, when all fees are considered, about 70% of gross returns on private equity funds were retained by the funds themselves.

A considerably stronger indictment comes from Simon Lack, a professional money manager and author of The Hedge Fund Mirage. In this book, he estimates that, from 1998 to 2010, hedge funds collectively returned just $9 billion to investors while lavishing an astounding $440 billion on their managers and other insiders.

While hedge funds and private equity funds are not synonymous, there are enough similarities among these sectors of the money management universe to suggest that such a skewed distribution may be somewhat indicative of the latter as well. Among the most commonly seen private equity fees are:

Management Fees

Management fees theoretically cover a private equity firm's operating expenses, although a growing body of research indicates that these fees typically far exceed the costs. Management fees usually are from 1.5% to 2.0% of assets.

However, in the early years of a private equity fund's existence, the management fee can represent a much higher percentage of the actual money invested.

It is because it normally also is assessed on all the cash that investors have committed to the fund, but which the fund has yet to invest.

Performance Fees 

Performance fees normally are about 20% of any investment gains recorded by a private equity fund. If the fund incurs a loss in a given year, performance fees are zero. Moreover, best practices in the industry dictate that, before performance fees can be earned, cumulative past losses should be offset against gains in succeeding years.

Deal Fees

Deal fees are charged by a private equity firm to the companies in their portfolios. They are supposed to cover various administrative services provided by the former to the latter.

Transaction Fees 

Transaction fees are charged by buyout firms to the companies that they buy. In the years 2009 and 2010, these fees tended to be about 1.24% of the deal size, for buyouts worth between $500 million and $1 billion, up from 0.99% in 2005 to 2008.

Monitoring Fees

Monitoring fees are paid by portfolio companies to their private equity firm owners to cover various consulting and advisory services.

Examples of Double Charging

These various private equity fees are coming under increasing criticism not only for being excessive but because they represent double charging for the same activities and services, assessed to investors and the portfolio companies simultaneously.

When portfolio companies go public, they often have to pay exorbitant amounts of fees to terminate their advisory agreements with private equity firms, even though the major source of profit for private equity and buyout firms is supposed to ensue precisely from taking portfolio companies public.

Some private equity firms assess a fee on portfolio companies for refinancing their debt. It strikes many observers as excessive, for two reasons. One, the private equity firms typically are responsible for piling on large amounts of debt in the first place, when taking companies private in leveraged buyouts (LBOs). Two, refinancing at lower interest rates increases the portfolio company’s profits, and thus the private equity firm's potential gains.

Investor Responses

An increasing number of investors are insisting that these various other fees should be used to offset the management fee, rather than serve as additions to it that create pure profit for the private equity firm, or support excessive compensation for its staff.

In response, roughly 83% of transaction fees associated with funds raised in 2011 is being returned to investors, versus 70% for funds raised in 2009. However, this may be offset by the overall increase in this and other fees.

Pension Fund Incentives

Money managers at various pension funds may have a perverse incentive to prefer redistribution of these various fees to their outright elimination. It is because rebated fees are often accounted for as increases to investment returns. It, in turn, will increase the money managers own compensation, especially if they are awarded bonuses tied to investment returns.

On the other hand, if the fees had not been charged, the arbitrary valuations assigned to the portfolio companies (arbitrary because they do not have equity traded and priced in public securities markets) probably would not have been deemed to have risen by a commensurate amount.

Sources: "Buy-out fund investors call for change in 'outdated' fee structure," Financial Times, November 7, 2011. "Private equity: Fee high so dumb," The Economist, November 12, 2011. "Private equity fees called into question" and "Fund management fee profits under scrutiny," Financial Times, January 24, 2012. "Rewards for failure: Hedge fund clients are paying a lot for a little, according to this devastating expose," Financial Times, February 18, 2012.