Private Equity’s Biggest Backers Are Tired of the Fees

Love the returns. Hate the fees. Is it time to go solo?
Corrected
From

The biggest U.S. pension fund isn’t happy. After years of paying steep fees to private equity fund managers, it’s plotting an end run. Officials of the California Public Employees’ Retirement System, which oversees about $337 billion, gave fund managers an earful at a pension board meeting on July 17 in Monterey. Huffed one CalPERS director: “I don’t see your industry standing up and justifying fees.” (The pension’s chief investment officer later said it would explore buying more companies on its own to lower fees and lift returns.) Firing back, Sandra Horbach, a top executive at Carlyle Group LP, one of the world’s biggest leveraged buyout managers, warned that CalPERS and other pensions looking for their own deals would be at a “strategic disadvantage” in a head-to-head rivalry with private equity firms like Carlyle.

Tensions over fees, which usually flare when times are lean, are nothing new. What stands out about CalPERS’s display of pique is that it comes at a time when private equity firms and their clients are basking in profit. As managers have unloaded companies they bought earlier this decade at low prices, they’ve returned hundreds of billions of dollars in winnings to investors such as CalPERS, which put up the equity for the deals that managers stage. Investors have routed the gains back to managers, pledging $221 billion to buyout funds in the first half of 2017, according to London-based research firm Preqin Ltd. The industry would break its fundraising record set a decade ago if that pace holds.

Illustration: Matt Murphy for Bloomberg Markets

And why not? Private equity returns have outstripped those of the S&P 500 over the long haul, even after fees. At CalPERS, buyouts have been the best-performing asset class over the past 20 years, averaging net annualized returns of 11 percent, compared with 7 percent for the total portfolio. But in recent years, returns have started to dwindle, and fees have changed little.

In line with CalPERS, retirement systems in New York, New Jersey, and North Carolina are among those reviewing their portfolios. Buyout firms aren’t deaf to the unrest among pensions, which are the biggest investors in private equity. To shore up clients’ loyalty, they’ve made concessions at the margins on fees. Since the early 2000s, a slew of advisory fees that private equity firms used to collect are now channeled to fund investors. Carlyle, Blackstone Group LP, KKR & Co., and other managers give top clients the option to co-invest extra money in deals alongside what they invest through funds—outlays that are free of fees.

What hasn’t changed an iota is the industry’s standard fee arrangement, known as 2-and-20. Even as fund sizes have mushroomed, managers have continued to extract a 1.5 percent to 2 percent annual management fee from investors on their committed capital while raking off 20 percent of investment gains as an incentive fee.

The payouts have transformed private equity’s leading players into potent money engines. Back in the days when private equity giants were young, management fees went to keeping the lights on. Nowadays they yield a geyser of profit.

“You don’t need that much to run the firm each year,” says Peter Keehn, the head of private equity at Allstate Corp., the largest publicly traded home and auto insurer in the U.S., with a private equity portfolio of $4.5 billion at the end of June. “People that still charge really high fees on big assets under management, those are the people that have gone public” or sold minority interests, he adds. “We see that as a real negative from an alignment standpoint.”

The firms, which declined to comment on CalPERS’s beef, aren’t without their defenders. “Nobody is forced to invest in a private equity partnership,” says Chris Kotowski, an Oppenheimer & Co. analyst who covers the industry. “The fact that people do is a sign of the fact that they add value.”

In 2016 at Blackstone, management-fee revenue per professional, including junior and senior staff, averaged $1.35 million—almost four times operating costs excluding compensation, according to data based on company filings. Incentive fees increased the average haul by $1.2 million.

With that said, many investors just don’t have leverage to push down the amounts they’re paying, says Karen Rode, the global head of private equity at Aon Plc, which helps advise $2 trillion in institutional assets in the U.S. “With fundraising so robust, managers could say, ‘Look, you guys are too difficult, I’m not going to put up with that, and I will fill your subscription with somebody else,’ ’’ she says. “Demand is so great, limited partners don’t have negotiating power.”

Still, performance isn’t what it used to be. Since 2012, net returns for the category have averaged 13.2 percent a year, more than a point below that of the S&P 500 index of public stocks, according to Cambridge Associates LLC, a Boston-based ­investment firm. In the 1990s, by contrast, private equity returns frequently averaged more than 20 percent a year and far outpaced the public market. “Investors are paying the same today for half the return” they used to get, says Andrea Auerbach, head of private equity research at Cambridge. “If the returns don’t justify the fees, the grumbling will get louder.”

Rather than grumble, some institutions have struck out on their own. Private equity investors such as Singapore’s sovereign wealth fund GIC Pte and investment groups created by ­computer billionaire Michael Dell, Chicago’s Pritzker family, and the Bechtels, who built Hoover Dam, have staffed up to steer deals solo. In 2015, MSD Capital, Dell’s investment arm, poached Doug Londal from New Mountain Capital, where he was president, to head its private capital group—adding to a team replete with Wall Street veterans. GIC in 2014 recruited Bradley Yale from U.K. buyout firm BC Partners LLP to lead health-care deals.

Many institutional investors are banding together to forge deals outside the ambit of the private equity establishment as a way to lowers costs. Allstate has started working with the Dell and Pritzker groups in pursuit of opportunities, according to people familiar with the collaboration.

Allstate’s Keehn says his company is working with more than a dozen such firms, as well as seasoned dealmakers who’ve left buyout firms and are now shepherding their own corporate takeovers. The effort has helped Allstate shed costs over a number of years, says Keehn, who declined to quantify the savings because of company policy.

For pensions in the U.S., Aon’s Rode says doing direct deals requires climbing over one critical hurdle: Many are underfunded, without the budget to hire staffs to invest like their Canadian counterparts, whose returns in buyouts soared after they opened their wallets to assemble skilled buyout teams. “Public pensions are under-resourced,” she says. “You really have to balance: How much do you outsource to third parties, and how much do you manage internally?”

Some large U.S. pensions are finding ways to trim fees without thumbing their noses at the Wall Street establishment. In an effort to woo king-size commitments for their latest funds, major fund managers have offered key clients a 50-50 split between what they invest through their funds and what they can invest alongside free of fees, according to a consultant who works with fund managers. What’s more, New York City’s pension funds and the Teacher Retirement System of Texas have struck deals with managers, including KKR and Apollo Global Management LLC, to invest massive sums in buyout, credit, and real estate deals that span the firms’ product platforms in exchange for fee breaks.

The volume discounts take deep pockets: TRS initially pledged a combined $6 billion in 2011 to separate accounts it formed with KKR and Apollo and later lifted the total commitment to $10 billion.

“We feel we’d rather partner with our general partners than compete against them,” says Eric Lang, head of external private markets for TRS. Yet there are a few investments the pension has done directly, he says, without specifying targets. Lang says the opportunities came through prior relationships.

“We feel that co-investing alongside our partners is helpful for us in many ways. It gives us a fee construct; it’s a way for us to get to know our general partners better; it also allows us to utilize some of their resources,” says Lang, who joined TRS in 2006 from real estate investment company Kennedy Wilson Inc. and previously worked at a unit of American International Group Inc. A year later, he made the decision to cut down the number of managers the pension worked with.

TRS trimmed its roster of fund managers by almost half, to 37. New York City is also considering a similar move after overall private equity returns failed to match the Russell 3000. “What you have here is the mathematics of a very large tail of unproductive funds weighing down performance,” Scott Evans, CIO of the city’s pensions, said in an April interview with Bloomberg. “This is an asset class where it pays to be narrow and to be deep with the partners you have confidence in.”

New Jersey’s directors have asked their consultants to find opportunities to sell their private equity stakes amid a “significant percentage of non-top-quartile funds,” according to minutes from the investment council’s meeting on March 29. North Carolina’s newly elected treasurer, Dale Folwell, in April told Bloomberg: “We don’t own alternative investments. They own us.”

For CalPERS’s quest to go it alone, challenges would be legion, starting with salaries. U.S. public pensions require budget approval from state legislatures, which likely would blanch at the prospect of paying near-Wall Street scale to attract the right talent. Canadian pensions, whose success with the do-it-­yourself approach has achieved legendary status in investor circles, have greater latitude with respect to pay than U.S. counterparts.

No executive knows the hurdles CalPERS faces in setting up a successful direct investing program better than Jim Leech. The chief executive officer of Ontario Teachers’ Pension Plan Board when he retired in 2014, he joined Ontario Teachers’ in 2001 to oversee its private equity group, which he built into a forceful rival to powerhouses such as KKR and Canada’s Onex Corp. His success—net returns topped those of public stocks by an average of 7 percentage points a year during his 12-year tenure—inspired other large Canadian pensions to stage their own deals.

For a pension such as CalPERS to pull it off, Leech says, it first must fork over money for good help. “We didn’t pay as much as KKR, but we paid well,” says Leech, now a senior adviser to Canadian Prime Minister Justin Trudeau and chancellor of Queen’s University in Ontario. “You can’t compete in the big leagues if you have a fourth-rate team.”

A second necessity is a board stacked with ­financial industry veterans who understand private equity and its risks and who are able to stomach losses when they occur, he says. Because it takes time to establish credibility with Wall Street financing sources, patience is a must. “It took Teachers’ more than 16 years to build the machine it has now,” Leech says. “You don’t do it in 10 months.”

To judge by what he told reporters at the July board meeting, CalPERS CIO Ted Eliopoulos has given the matter a lot of thought. He said CalPERS would move into direct investing slowly, first assembling a legal structure for running companies and then methodically building expertise over five or more years.

Just eight weeks later, though, news surfaced that CalPERS was weighing a radically different course—to outsource some or all oversight of its $26 billion private equity portfolio to BlackRock Inc., the New York money manager. How this might contain fees is unclear. Unless CalPERS sells its existing positions in buyout funds—a complex and time-consuming ­procedure—it would be paying two layers of management and performance fees. (CalPERS spokeswoman Megan White declined to comment.)For CalPERS, breaking free of Wall Street’s fees will be easier said than done.

Basak covers insurers and boutique investment banks. Carey covers private equity. With assistance from John Gittelsohn

 

(Corrects assets under management figure in tenth paragraph.)