(August 8, 2012) – 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. aiCIOreported 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.”