The Financial Times had an interesting article on July 12 about Calpers admitting that it had not tracked the fees it had paid to private equity managers over the last 25 years. Given the SEC crackdown on excessive and hidden fees from some of the largest PE funds in America, the call for Calpers self-examination is not surprising. What does surprise me is the increasingly popular implication that high fees hurt relative returns.
The PE asset class has outperformed most public and private asset classes over the long haul measured by 10, 15, 20, and 25 years. The cumulative fees paid to managers that produced those outsized returns were probably “astronomical” as a Calpers official has speculated. But shouldn’t the question be “Is the manager fairly compensated for the skill he brings to the outlier investment result?” I think we could have a pretty interesting debate about the relative value of returns in products like life insurance, annuities and “high load” mutual funds that carry heavy up-front fees. They are accrued and often paid even before the product experience begins and in many cases are a higher percentage of total returns than the traditional “2% and 20%” private equity compensation scheme.
It also should be noted that the 2% annual management fees that are paid to PE managers are really a reimbursable expense (working capital advance by investors) repaid out of the first tier of future realizations. The only time you fail to recoup the annual management fee is if your fund profits and “fund offsets” are less than the cumulative annual fees. This is rare and I do not believe it is an area of scrutiny for the SEC or consultants who score the managers. Rather it is the 20% “carried interest” that is catching everyone’s attention. The amount of fees is staggering but so is the outperformance of the asset class over a long period of time. The way I was taught to do the investor math is to compare all products net of fees on a pre-tax basis and, if you have the information and sophistication, net of taxes as well.
What is most surprising to me is that the PE Industry has not banded together to defend itself and its track record. Maybe it is because the largest firms are public already and have their hands full with daily compliance? Or maybe it is the hope for privacy and anonymity- flying below the radar- that keeps spokesmen on the sidelines? As shown in the chart below Cambridge Associates shows in its March 2015 report on U.S. Private Equity and Venture Capital Funds that private equity and venture capital have both outperformed publicly traded securities of all types over the long run (the last 10, 15, 20 and 25 year test period) and, in many cases, over the short term as well (1, 3, 5 years). Note the bold numbers show the outperformer:
U.S. Private Equity and Venture Capital Index Returns (%)
|Russell 2000 Composite||9.7||4.9||19.2||15.6||7.8||7.4||9.6||9.8|
Sources: Cambridge Associates LLC, Frank Russell Company, Standard and Poor’s, and Thomson Datastream. * Capital Changes Only
The consultants can challenge these returns because they include a “survivorship bias” inasmuch as the PE firms that failed are no longer reporting to Cambridge. But I also imagine (but have not been able to confirm) that the returns for the public indices are gross and not net of fees for the products that try to mimic them? In any event, there is a remarkable outperformance by Private Equity over a 25 year period of already dramatic wealth creation in the US Capital Markets.
The problem with Private Equity is not the fees. It is the reluctance of a small group of extremely private and successful people to defend themselves. I understand their frustration. In some cases it is simply better to fade away and retire than end up in a shouting match with the SEC, the populist media or, even worse, a member of Congress. Maybe our industry needs a political PR machine? There could be some excess capacity in that industry soon.
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