Pay to play: Australia's fee debate

"Did you see the Australian Financial Review this morning? Why was that session open to the media?" asked the head of private equity at a superannuation fund on day two of the recent AVCJ Australia & New Zealand Forum. "I'm probably going to get phone calls from a few trustees asking why we still invest in private equity. It really doesn't help when we air our dirty laundry in public."

This was feedback on a panel discussion that addressed whether private equity is overpriced and underperforming. It is an issue that runs to the heart of tensions between Australia's LP and GP communities. The former are disillusioned with local managers and unhappy about paying a premium for exposure to the asset class; the latter see the response to this - abandoning PE completely or at least abandoning Australian funds - as illogical and unlikely to deliver long-term success.

It remains largely a domestic concern yet several of the sub-themes resonate globally. To put the situation in a broader context, it is one aspect of post-global financial crisis self-assessment. The vast majority of Western LPs, having been swept up in the euphoria of 2005-2007 and subsequently seen some of their investments falter, are on a similar journey.

These debates take place in different contexts and they reach different conclusions, but many of the same questions are being asked, regardless of geography. What is an appropriate level of compensation for fund managers? Should fee structures and the limited partnership model be redesigned? How must LPs adapt to sate their newfound appetite for co-investment and secondaries, and could they eventually exclude GPs altogether and go direct?

Mark Carnegie, founder of M.H. Carnegie & Co, is among those who think the current approach is irretrievably flawed and must be replaced.
"I think the deal between the working men and women of Australia who have entrusted their retirement savings to you guys and what you give to an underperforming PE fund manager is absolutely unconscionable," he told the forum. "The idea that this is an industry that allows someone barely out of university to be getting five times household weekly earnings, without any background and to have no skin in the game, strikes me as absolutely obscene."

Carnegie's remarks were controversial - which is why local media ran with them - but unfairly judged when extracted from the context in which they were presented. This wasn't so much a savaging of the asset class as of the 75% of managers who sit outside the top quartile. A manager capable of delivering an IRR in excess of 20% to his investors deserves a yearly management fee of 2% and a 20% share of the profits from his deals. The problem is the long tail of underperforming private equity funds where managers still get paid despite failing to meet expectations.

Some good, some less so

The explosion of interest in private equity in the mid-2000s saw several strong Australian private equity firms attract more capital than ever before and deploy it effectively. But a host of less experienced managers were able to ride the same wave.

A total of 11 Australia-focused funds attracted commitments of $504 million in 2003. Within three years the number grew more than eight-fold to $4.3 billion before peaking at $6.9 billion in 2007. Last year, industry fundraising fell just short of $1.3 billion. Investment soared from $2.5 billion in 2005 to $16.7 billion the following year and $15.4 billion the year after that, supported by a lot of the global and regional players started targeting the large-scale buyouts in Australia.

"We should recognize the reason why performance has declined so dramatically in this industry in the last 15 years is because it's outgrown its space," said Peter Wiggs, managing partner at Archer Capital. "We have crowded ourselves out of returns. The LPs gave the money to the GPs and the GPs spent it on dodgy deals and then we all lost it. That's what happened."

He contrasts Archer's habit of imposing strict limits on fund size and its consistent investment strategy with the industry's pre-global financial crisis tendency to raise as much capital as the market was willing to give and then pay inflated sums for assets. This took the buyout share of overall M&A from its normal level of about 5% to more than 20%, and it couldn't be sustained.

While GPs are guilty of overreaching, the LPs slipped up in manager selection.There is plenty of criticism of institutional investors' alleged predilection for "box-checking" due diligence where a GP is credit-scored without sufficient attention paid to the nuances that are difficult to quantify yet make the difference between a top quartile private equity firm and a bottom quartile one. The implication is that, by obsessing about fees, LPs will once again struggle to identify leading managers and settle for what is safe yet mediocre, missing out on stellar returns.

"There has been a lot of debate about private equity in Australia but I would question whether it's the asset class or the way it has been implemented within people's portfolios, driving some bad outcomes," noted John Brakey, head of private equity at MLC.

The economics

It is clear what LPs want from private equity - outperformance of listed equities in order to justify tying up capital in an illiquid asset class. According to Michael Weaver, a portfolio manager at Sunsuper, a 5-6% per annum premium is expected. If public equities deliver net returns of 9-10% in the long term, then private equity must reach 14-15%, which implies a gross IRR of more than 20%.

That difference between gross and net - i.e. what the fund is getting for managing the assets - found new prominence in 2010 with the publication of the Cooper Review. It highlighted the management expense ratio (MER) of pension plans and so private equity, where the fees are high compared to other asset classes, became a focal point. Were members getting value for money?

The introduction of MySuper as a low-cost alternative to the incumbent superannuation providers presented another complication. Suddenly members were able to switch programs at short notice, with significant implications for cash flow and asset liability management. Private equity was damned not only for its fees but also for its long-term and illiquid nature.

Faced with a choice between investing in one asset class where performance was uncertain but fees were certainly high and another that offered lower fees but less potential upside, many superannuation funds went with the budget option.

It is said to cost 600-800 basis points to invest in private equity via traditional fund structures. Two thirds of this cost is the management fee, the rest is the performance fee. If a superannuation fund has a total MER budget of 70 basis points and a private equity allocation of 5%, PE will use half of the budget for a fraction of the portfolio, with no guarantee of investment outperformance. Furthermore, the fees are calculated based on committed capital, not invested capital.

The problem is, of course, the underperforming managers. For every fund that comfortably exceeds expectations, there might be 2-3 that do not - and superannuation funds look at the returns on the entire portfolio. Ross Barry, head of portfolio construction at Towers Watson in Australia, put it thus: two thirds of the funds in the portfolio have generated an IRR of 15-20% while the other third contributes nothing, which produces an overall return of 12%. Factor in management fees and this drops to 8-9%, because the one third of managers who failed still receive compensation.

"The superannuation funds have gone through a whole lot of pain and suffering, board time and investment committee time, and the complexity and cash flows and dealing with tax and legal fees that they wouldn't otherwise have to worry about - and they've basically got a listed market return at the end," said Barry. "That is why they say, ‘Why do we bother?'"
Barry goes so far as to suggest that the GP model doesn't work for institutional investors. He described it as "a bit of a Trojan horse to get investment banking into institutional wealth management," and expects alternative models to emerge.

Indeed, these alternatives are already beginning to surface globally, as illustrated by the largest and most sophisticated LPs becoming direct investors - either independently or on club deals - and excluding the GP entirely. The argument goes that there are certain areas, infrastructure being a good example, where a pension fund's 50-year horizon isn't best served by operating through a manager who is mandated to exit investments within 10 years.

This could be seen as a natural consequence of the concentration of institutional savings into a small number of very large funds. In the space of seven years, the number of superannuation funds in Australia has fallen from 1,300 to about 350, according to Towers Watson. Based on this development, it expects there to be fewer than 100 super funds by 2020 with at least five of them having more than A$100 billion under management.

The likes of QIC, MLC and Future Fund are already building out internal teams and making direct investments into international GPs as opposed to through fund-of-funds. Some of their domestic counterparts are tipped to follow suit and will offer stronger capabilities in terms of co-investment and secondaries, both of which are becoming increasingly important as LPs. Co-investment offers lower costs while secondaries provide net asset value from day one, so both can theoretically reduce the gross-to-net return spread. Is direct investment the logical summit of these ambitions?

"What is happening within some superannuation funds right now and the move to set up direct teams, that is a train wreck waiting to happen," said MLC's Brakey. "If they were good enough to be a GP then they'd be a GP. But they're not. If you do a bad deal or two, that's going to cost you more in performance than whatever you save in fees."

Ultimately, success is a function of skill and resources; some will make the transition and others will not. If they do remain predominantly as investors in blind pools - and there are alternatives to a direct strategy, such as separate accounts with managers - they can take advantage of fragmentation in the 2/20 fee structure. Or maybe not.

All their own way

For those managers in the top quartile, the fees debate is of little concern as they still see strong demand from LPs. There is a general interest in seeing superannuation funds overcome these issues so that members have the opportunity to benefit from exposure to the asset class, but there is no real need to compromise on terms.

"If you don't like paying the fees, don't invest - it's that simple," said Archer's Wiggs. "You need to ask yourself no other question. I don't care it's because of MySuper or Bill Shorten [Australia's minister for financial services and superannuation] or your politics - don't bore me with the reason. I have no interest, just do me the courtesy of saying no so I don't have to fly to Melbourne to be told no."

And Carnegie, though keen to see more alignment between GPs and LPs, is adamant that top quartile performers deserve top quartile compensation. He would rather invest his own money than work of a fee structure that isn't approximating 2/20 - as long as the IRR being delivered remains above 20%, of course.

One solution to the stand-off, suggested by Wiggs, is to follow the example of capital markets and let demand and supply decide. Private equity fundraising could operate much like the book-build for a debt or equity issue with investors submitting bids for LP interests. A respected manager with a strong track record might find he is even able to command fees of 2.5/30 as opposed to the traditional 2/20. Such is the price of access.

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