Thursday, August 9, 2012

Turning the Tables on 2-and-20?

Leanna Orr of aiCIO reports, Turning the Tables on 2-and-20:
Four out of five institutional investors agree: a 2% management fee is unacceptably high.

Private equity managers are facing unprecedented pressure to scale back fees, according to a recent survey of 100 leading institutional investors in private equity by PEI. Chief investment officers and their staff are pushing back against the pricey, opaque world of hedge funds despite a growing sentiment that alternative investment sector is the only class capable of hitting return targets.

“The data illustrates two major industry trends,” said Amanda Janis, a senior editor at PEI, in a statement. “If you are a private equity manager, then fundraising through the recent economic crisis has—with a few notable exception—been a challenging experience because capital has been scarce. This has allowed limited partners to band together and push for lower fees and other more limited partner-friendly fund terms. The two-and-20 fee structure was designed in a different era, when private equity funds were smaller.”

This isn’t just an American trend, either. aiCIO reported in June that major European and global fund managers, representing about £6 billion (US$9 billion) in assets, had, on average, lowered their fees. Just as in the US, many—roughly half—of overseas managers reported an increasing prevalence of clients challenging fee structures, particularly where they had underperformed the relevant market index.

For a long time, institutional investors stateside had been "begrudgingly going along with what sometimes seemed like egregious management fees, because the funds still generated good returns,” according to Janis. “Nowadays two-and-20 looks to be the exception rather than the rule.” The push-back against these traditional fee structures indicates a shift in power from private equity managers to institutional investors. An impressive 85% of survey respondents said they had been approached by at least one manager for a fund extension in the last year.

And when these funds don’t raise the capital they need—whether due to poor returns, unconvinced investors or both—they become serious worries for the investors that have stuck around. Four out five institutional investors expressed concern over ‘zombie funds’ in their portfolios, which are funds with such poor performance that the manager survives on management fee income, and has no real prospect of raising a follow-on fund.

“Zombie funds are often seen as the first step towards a GP winding down,” said Larry Oberfeld, a senior analyst at PEI, in a statement “Many firms are often able to stay open by relying on management fees coming through from earlier deals. However, limited partners who end up paying these fees for a longer period find their investment returns are diluted in the long term. Such issues have encouraged limited partners to increase their communication with other investors in funds in order to improve their knowledge and negotiating power.”

And some investors are not just getting rid of 'zombie funds', they're increasingly shifting out of funds, opting for direct investments, or (more likely) investing alongside of them, co-investing to lower fees.

Bloomberg reports that PSP Investments is shopping around for $1.5 billion in fund stakes:

The Public Sector Pension Investment Board, one of Canada’s largest pension-plan managers, is returning to the secondary market to shop about $1.5 billion in private-equity fund stakes, said two people with knowledge of the matter.

The portfolio for sale is made up of concentrated positions in large buyout funds managed by private investment firms including Apollo Global Management LLC (APO) and Apax Partners LLP, according to the people, who asked not to be identified because the information isn’t public.

Cogent Partners, an advisory firm based in New York, is managing the sale. Mark Boutet, a spokesman for Montreal-based PSP Investments, declined to comment.

PSP Investments, with C$64.5 billion ($64.7 billion) in assets under management as of March 31, is increasingly focusing on making co-investments alongside private-equity firms or investing directly in deals, while being more selective about new fund commitments. The pension manager brought a similar-size portfolio to market in 2010, ultimately selling stakes in a number of mega-buyout funds for more than C$800 million, according to its fiscal 2011 annual report.

Direct and co-investments accounted for 34 percent of assets in the private-equity portfolio as of March 31, compared with 32 percent at the end of the previous fiscal year, the plan’s 2012 annual report shows.

North American pension plans are accessing the secondary market, where investors sell their stakes in private-equity funds, to rebalance their holdings. California Public Employees’ Retirement System and State of Wisconsin Investment Board are both seeking to sell fund stakes to reduce the number of managers they use and concentrate bets with the best performers, people familiar with those pension plans said earlier this year.

PSP invests on behalf of the Public Service, the Canadian Forces, the Royal Canadian Mounted Police and the Reserve Force. Private equity accounted for 10 percent of the portfolio as of March 31.

I already covered PSP's fiscal 2012 results and mentioned that Private Equity matched its benchmark, delivering a solid gain of 7.7%. I helped Derek Murphy set up PE at PSP and along with Jim Pittman, they moved quickly to shift into directs and co-investments.

In this environment, there is no question that LPs are the ones with leverage and they're hammering funds on fees.

Yet despite the tough environment, some funds are having no problem fundraising. Bloomberg reports that Carlyle Group, the Washington- based investment firm that went public in May, posted a loss in the second quarter as the value of its private-equity holdings declined:

The shortfall, excluding some costs related to its initial public offering, was $58.9 million compared with a profit of $236.8 million a year earlier, Carlyle said today in a statement. Carlyle had a loss of 19 cents a share after taxes, missing the average estimate for a 4 cent loss by nine analysts in a Bloomberg survey.

Carlyle, the world’s second-biggest private-equity manager, is expanding beyond buyouts in a volatile global economy that has quelled deal-making and managers’ ability to reap profits by selling companies. Private-equity rivals Blackstone Group LP (BX) and Apollo Global Management LLC (APO) also reported lower second-quarter profit as market swings hurt the value of their holdings and hampered their ability to sell or take their companies public.

“Realization activity was relatively muted, driven by uncertain capital market conditions,” Roger Freeman, a Barclays Plc analyst, wrote in a July 24 note to clients about the so- called alternative asset managers. “Fundraising continues to be strong across the group, driven by credit, infrastructure and natural-resources funds.”

Like other large PE firms, Carlyle is moving into hedge funds and other alternative investments to offset slowing revenues from private equity investments. Interestingly, 2 & 20 still reigns supreme in Hedgeland but that too is unlikely to last as more and more investors realize they're getting burned by slick charlatans charging alpha fees for beta.

Investors should pay attention to quarterly results from PE firms that went public. Same goes for AIG's results, which showed strong gains in Q2 despite lower income from alternative investments. These quarterly results provide clues to the state of alternative investments.

There should be a wide discussion on 2 &20. I am of the school of thought that most managers don't deserve these fees and even the ones that do are raping investors. In fact, I would argue that hedge funds and private equity funds managing billions should only charge performance fees.

Below, Bloomberg's Cristina Alesci reports that Carlyle Group LP, the Washington-based investment firm that went public in May, posted a loss in the second quarter as the value of its private-equity holdings declined. She speaks on Bloomberg Television's "In The Loop."

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