Source: www.breakingviews.com is Europe’s leading financial commentary service.
Investment banks aren’t the only ones experiencing a fees squeeze. Private-equity firms are also feeling the pinch. Not that you’d know it by some of the headlines. The two primary ways in which they make their money have not been noticeably hit. Management fees, typically an annual charge of 1.5% on the total size of a fund, are unchanged. So is the proportion – usually 20% – of returns that managers of leveraged buyout funds get to keep of the profits generated by the investments they make.
But a closer look at a couple of recent funds shows that even some of the stars of the sector, such as Permira, are making concessions to appease investors. So, too, are firms with more mixed recent performances in some funds, such as Doughty Hanson or Hicks Muse Tate & Furst.
The latter, in particular, is offering sweeteners to attract investors to its new e1 billion fund. For example, Hicks Muse partners will invest three times as much of their own money as the industry norm. They are also promising not to extract their share of the fund’s profits until investors receive all their committed capital back.
Permira also threw a few scraps to investors. It closed its e5 billion fund after less than a year of fund raising. The stellar returns generated by its 1997 fund and the fact that it had handed back a quarter of its 2000 fund to investors meant it practically sailed through the money-raising process.
Nonetheless, it agreed to a couple of requests, notably an agreement to cap transaction fees that it charges the companies it buys and sells. These are like the fees investment banks charge companies but, in the case of private-equity firms, are ultimately borne by a fund’s investors. Permira, which historically shared these fees with its investors, has now also agreed to hand them any fees above e200 million that it clocks up during the life of the fund.
That may not sound like much of a concession. But the fact that Permira made it, even though its fund was oversubscribed, reflects the growing tide of activism among many investors, particularly US pension funds.
Private equity has become a buyer’s market – 50% less money was raised in the first nine months of the year than the same period in 2002, according to AltAssets. This reflects the fact that many funds have been unable to exit from investments made during the bull market. At the same time, the total funding allocation from which pension funds put money into leveraged buyout funds got smaller with the bear market. Without money being returned from existing funds, many investors are reticent to double up.
This situation has put investors in the driving seat. And they are understandably pushing to align the interests of fund managers with their own. After all, to private-equity purists the raison d’être of a fund is to acquire companies using debt and sell them within a few years for a higher price. The problem is that in recent years, private-equity firms have found other ways to generate money that many investors feel have reduced the firms’ motivation to make a killing.
The biggest of these has been management fees. These have ballooned in money terms as fund sizes have surged. (Permira will earn e75 million a year in management fees alone.) As a result, some investors are pushing for these fees to come down as the sizes of funds increase – similar to the way investment banks employ a sliding scale that gives them a lower percentage of a deal as a fee the bigger the transaction.
So far, only a few of the largest investors in funds have been able to reduce the management fees they pay to fund managers. But as investors score more modest victories in the areas of transaction fees, it is likely that management fees, too, will face the eventual squeeze.
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