Private Equity's Gravity-Defying Fee Bonanza
One corner of the investing world is surprisingly immune to the widespread trend of shrinking management fees: private equity.
Despite lower fees at firms from BlackRock Inc. to Brevan Howard Asset Management LLP and across most types of funds, many private equity managers are charging investors roughly the same amount as they were several years ago. This was on display this week in a Bloomberg News article by Janet Lorin in which Yale University’s endowment discussed how it negotiated management fees and terms.
While it could effectively push for lower costs at many types of funds, Yale said, it has "little bargaining power" in some markets, including leveraged buyout and venture capital, according to the article. Top-tier firms "present the greatest challenge" because of overwhelming investor demand, the endowment said.
Indeed, investors are piling into private equity strategies at a shocking pace, with $347 billion raised among 830 funds closed last year, bringing the industry’s assets under management to all-time high of $2.5 trillion, Preqin data show.
Compare that with the hedge fund universe, which in 2016 had its first year of net withdrawals since the financial crisis. Active mutual funds have also struggled to retain assets while passive funds rake in money by racing one another to lower their fees.
Given this disproportionate investor stampede into private equity, it’s not surprising that private equity firms have been able to charge roughly the same 2 percent management fee that used to be the norm among hedge funds. This rate has remained relatively constant since 2007, Preqin data show. The average hedge fund management fee, in contrast, has fallen to 1.48 percent, according to HFR data.
This all raises the question, are private equity firms worth the high fees they charge? Returns have, indeed, been stellar, with 95 percent of investors believing that their private equity investments have met or exceeded their performance expectations over the past 12 months, up from 81 percent in December 2011, according to a 2017 Preqin report.
Of course, a Bloomberg News article on Thursday called into question whether private equity firms were inflating their returns using a practice that is entirely legal but could make even mediocre funds shine in good times. As my Gadfly colleague Gillian Tan noted, the use of this tactic makes it difficult for investors to compare performance across different funds. Still, these funds have generally performed well in recent years, riding a wave of central-bank stimulus that’s bolstered valuations at companies they focus on. Going forward, however, it’s easy to imagine that the private equity industry will eventually lose some of its luster and, consequentially, its outsized fees. Returns are already expected to decline somewhat from recent high levels. Performance would most likely deteriorate much further in the case of another economic downturn.
First of all, corporate valuations are incredibly high, raising questions about how these firms are going to spend their record stockpiles of cash effectively. Second, short-term interest rates are rising, crimping managers’ ability to borrow money cheaply to juice returns, as they’ve been doing of late. And third, a growing proportion of companies owned by private equity firms are running into trouble, especially in the retail industry. At some point, this will eat into fund returns.
Private equity can't remain relatively immune forever. At some point, returns will likely start sagging, and the industry's fees will follow suit.
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