Pauline E. Ranger A new study provides insight into the opaque world of private market funds and their fee structure.
Over the last decade, private equity and unlisted funds have become mainstream assets due to torrential capital inflows. By 2025, personal assets will be worth more than $17 trillion. This is a 60% rise over the previous year. The boom is due mainly to defined-benefit pension plans seeking higher returns from stocks and bonds than they could get through bond investments.
Fund managers are urged to be more transparent about their fees as more public funds have been invested in private investments. The Securities and Exchange Commission opened a new window and suggested that private equity fund managers report quarterly standardized data on fees and expenses. This was in response to a “risk alert, “opening a new window that found that funds gave investors inaccurate or misleading information about their performance.
Private equity fund managers charge “2and20” — a management fee of 2% and a performance fee of 20% if benchmarks are beaten. Investors are also responsible for hidden costs such as legal and consulting fees incurred by portfolio companies. These extra costs have been criticized by investors, who also questioned PE managers’ use of private planes.
In a recently published, Juliane Beenau, associate professor of finance, Stanford Graduate School of Business, and Emil Siriwardaneopens, in a new window of Harvard Business School, shed light on opaque fees within private market funds and private equity. Begenau says that the private capital industry is very secretive. Everything is negotiated bilaterally. As we are taught in business schools, transparency of prices is linked to a well-functioning market.
The same fund, different fees
Investors pay different fees in the same private fund. This affects their return. The average estimated divergence between funds is 0.9% for management fees and 5.8% for performance fees or carry.
Also, there are differences in the performance fees of different asset classes. The most significant differences in performance fees are between private debt and real estate funds — 6.8% and 6,4%, respectively. Venture capital funds have a carry dispersion of only 0.5% due to the standardization of contracts with investors.
Begenau said policymakers could consider requiring private funds to standardize contracts with pension plans. However, she warned that this might restrict their access to the private market. If you charge the same fees as other funds, some may withdraw and not deal with pension plans.
Begenau discovered the divergence between private market fund fees when he studied the net returns earned by two invested in the same fund simultaneously. For the first decade, their returns were similar. After that, however, there was a significant difference, with the first investor earning $1.62 for every dollar invested and the second making $1.54, suggesting they had been charged different fees.
QuoteThe private capital market is very secretive. But, as we teach in business schools, price transparency is correlated with well-functioning markets.AttributionJuliane Begenau
Begenau, using machine-learning techniques, assessed a dataset of $438 billion in investments made by over 200 U.S. pension funds in 2,400 private funds. The results revealed that the majority of funds need to set fees uniformly. Instead, they tend to cluster investors into different fee levels. In the sample of funds, 36% had one fee tier, 61% had two, and the rest had three or more.
Begenau also found that the type of law firm used by a fund’s private market is essential in determining why certain funds use multiple fee structures. She says that some private equity funds are more likely to use various fee structures if they have a relationship with a particular law firm. This suggests a contractual explanation.
This also explains why venture capital funds have a lower likelihood of tiering investors (by 33 percentage points) than private equity funds and a 48 percentage point lower likelihood than infrastructure funds.
The research also found a negative correlation between the demand of investors and the use of multiple fee structures. Fund managers with no track record have a 13 percent higher likelihood of tiering investors. Funds with low subscriptions are likelier to charge fees by 12 percentage points.
Private capital funds that use placement agents to connect investors and funds are also more likely than others to charge tier fees. Agents are taking a cut from the money they bring, and the funds will pass the cost on to investors. Begenau explains that this is a way to skim off fees from pensions. Some pensions try to reduce costs by restricting the use of private market placement agents.
Lower Fees for Big Investors
Begenau cites signaling effects for the fee tiers. She says that you might miss out on profitable investment opportunities if it takes too long to close a fund. Therefore, you are likelier to give fee breaks to encourage more capital commitments. She believes fund managers will reduce fees for large cornerstone investors, which would provide them with confidence in the fund. She says you can cut a deal with CalPERS, the largest public pension fund in the U.S., to gain their support.
Fund managers often offer fee reductions for investors who help reduce the cost of raising funds. As a result, certain public pensions pay lower fees on average across their entire portfolio. The study found that the largest pensions, and those who contribute the most money, are more likely to fall into the lowest fee tier.
Investor sophistication is another crucial factor: Pensions at lower fee tiers are more well-governed, have more experience, and had a good performance in the past. Begenau says that the labor market plays a role in this. The labor market for talent in public pension investments is often rigid and has price ceilings. When private equity is the opponent, it is hard to expect efficient negotiations.
The total amount of capital loss due to fees, calculated as $4.30 for every $100 invested or $19 billion across the dataset, is $4.30. It does not mean that pensions have behaved unoptimal, as some may have chosen to pay lower fees in exchange for more experienced fund managers. Begenau says that you can still profit even if you pay more fees. This is because paying higher prices can be more appealing than investing in the public markets.
She says that until fees are more transparent, pensions will pay different prices to access private markets.
