Taking the Guesswork Out of Private Equity Fees

After years of pushing private equity firms to change, investors finally have a clear set of demands.

After nearly five months of revisions, discussions, and reviews, last week the Institutional Limited Partners Association (ILPA) debuted its new fee disclosure template—a straightforward Microsoft Excel spreadsheet intended to revolutionize how private equity firms report fees.

The template is the brainchild of the ILPA’s Fee Transparency Initiative, an effort to drive uniformity and clarity in reporting practices across the industry. The final product is organized into two parts: Section A, detailing the direct costs of participating in a given private equity fund, and Section B, a breakdown of fees, incentives, and reimbursements received by the general partner (GP).

The completed guidelines reflect the input of more than 120 individuals and organizations around the world, including nearly 50 limited partners (LPs) and 25 GPs. In addition to the industry group’s more than 300 member organizations, the initiative is backed by LPs including the California Public Employees’ Retirement System (CalPERS) and the Teacher Retirement System of Texas. 

Jennifer Choi, ILPAJennifer Choi, MD, Industry Affairs, ILPA“The goal is really to try to influence and effect a shift toward industry-wide standards in reporting on fees and expenses,” Jennifer Choi, managing director of industry affairs at ILPA, told CIO. “At the end of the day, that’s really what this is about.”

The much-needed makeover follows a period of criticism for the private equity sector and its opaque and expensive fees. In 2015, CalPERS announced plans to dump two-thirds of its private equity managers while the US Securities and Exchange Commission (SEC) fined PE powerhouses KKR and Blackstone a combined $69 million for charges related to improper fee disclosures.

In July, a coalition of 13 public pension funds appealed to the SEC to require clear and consistent private equity fee reporting. In October, SEC Chair Mary Jo White responded with promises that the regulator would continue to scrutinize the funds’ fee and expense practices.

“There’s no uniformity within the private equity industry as to what gets reported and how it gets reported,” said Scott Jacobsen, a private equity investment director at CalPERS. “The level and type of disclosures can be different from one general partner to another.”

This discrepancy in fee reporting makes it difficult for LPs to accurately evaluate managers—and makes it easy for GPs to profit in ways that are sometimes unfair or even illegal, as in the case of KKR allegedly charging investors $17 million for unsuccessful buyout bids.  

“The private equity industry has made some good money on hidden fees and costs,” said Ashby Monk, a senior advisor at the University of California’s Office of the CIO and executive director of Stanford University’s Global Projects Center.

In fact, a recent study from Oxford’s Saïd Business School and the Frankfurt School of Finance & Management found LPs paid $2 billion a year for portfolio company fees—on top of management fees and carried interest.

“Frankly, I think getting to the bottom of where all those costs and fees are being hidden so that LPAs [limited partnership agreements] can be negotiated from a position of mutual understanding is important,” Monk continued. “Right now we’re negotiating agreements with too much gray, and we’d much rather see those gray areas defined in black and white so that everybody knows exactly what incentives are being created.”

“There’s no uniformity within the private equity industry as to what gets reported and how it gets reported.”Some LPs have been trying to muddle it out for themselves, conducting internal reviews of their private equity portfolios. The New Jersey Division of Investment determined last spring that it had paid out a total of more than $600 million in fees to alternatives managers from 2012 to 2014. CalPERS reported in November that it had paid $3.4 billion in performance fees to private equity managers over the last 25 years.

“LPs are trying to get a better handle on costs across their entire portfolio, including private equity,” said ILPA’s Choi. “It’s critical that they have the data and the tools to do that.”

The ILPA is first to provide such a tangible tool: Its reporting template is intended to standardize disclosures on fees, expenses, and incentive allocations. Choi said the new template is likely to benefit investors first because it is a quarterly report, as opposed to the typical annual fee reports, and second because it would create consistency in which fees are disclosed—and how—if widely adopted.

But will the template be adopted? Choi is confident, even if the process might take some time.

“In the end, LPs will have to demand it or it won’t take root. Otherwise it just becomes another white paper.”“As with most things and most industries, you’re going to see the largest players—whether they be LPs or GPs—take the step first,” she said. “Certainly as the big GPs take this up we expect that over time it will be a natural ripple effect as more of their LPs begin to ask for this information from other managers.”

Already the template has been publicly endorsed by 25 LPs including the Canada Pension Plan Investment Board and the New York State Common Retirement Fund, along with the aforementioned CalPERS and Texas Teachers. Meanwhile two GP endorsements have come from the Carlyle Group and TPG Capital.

“We have been asking and requiring our general partners to provide this level of disclosure already, including as part of our legal contracts that GPs will provide this information in the ILPA fee template,” said CalPERS’ Jacobsen. “We have also been encouraging other large LPs to do that with their GPs.”

Once ILPA’s transparency standards become widely established, Monk argued GPs will be “hard-pressed” to explain why they wouldn’t agree to the template.

“Any GP that wants to be in the business for a long time and is asked by a large LP to provide this level of transparency should provide it—and if they’re not providing it, then they’d better have a pretty good reason,” he said.

This increase in transparency will be an important step for GPs if they want to improve their relationships with LPs, said Robert Lee III, director of investments at the Employees Retirement System of Texas. Lee, who serves on the board of directors of the Alignment of Interests Association—ILPA’s hedge fund counterpart—said he was “very happy” to see the industry group tackling fees.

“It’s not going to uncover any bad actors or cause anyone to think more or less of a fund, but it helps build trust between GP and LP, which has been flagging,” Lee said of the template. “And trust is the basis for a partnership.”

While improved transparency around fees could have some downsides—such as scrutiny from people who “don’t necessarily understand private equity”—he said the resulting trust would be worth it.

“In the end, LPs will have to demand it or it won’t take root,” Lee said. “And I think they will. Otherwise it just becomes another white paper.”

Related:  Limited Partners Swell Ranks as PE Battle Intensifies