The demand for Private Equity investment since the Financial Crisis has been nothing short of insatiable. Without question this segment of equity provides welcome portfolio diversification. Having said that, from time-to-time, it is most prudent to review a few of the items on Private Equity’s long list of nuisances. This article does just that.
Fees Charged on Committed Capital
Many Private Equity funds charge management fees based on investors’ committed capital as opposed to their invested capital. Therefore, a slower allocation process can negatively impact investors’ net returns. A better formula would be for the investor to have a fee computation based on invested capital only, or alternatively have a two-tiered fee structure whereby capital that is not invested is charged a fee that is lower than the fee for capital that is in fact invested. Another fee structure would be one with a low or no management fee. However, it would require a higher carried interest component to ensure fair alignment between GP and LP. As an aside, the industry is beginning to witness smaller funds that offer zero management fees and carried interests of 20%-30% on success.
Horizon Conflicts Between GPs and LPs
Quick exits and dividend recapitalizations indeed boost internal rates of return, which is the key performance metric for Private Equity. Though LPs do benefit from the related short-term performance boost, returning cash too quickly can create the problem of having to redeploy that capital into other investments which may not always be easily done. Investors ideally want to be able to put Private Equity capital to work for 6-10 years. Basic time value of money theory explains why GPs do not always serve their LPs’ best interests. As such, they are motivated to fully or partially realise their investment return as quickly as possible. Therefore, in contrast to LPs, GPs prefer quick flips and care about generating attractive carried interest for themselves.
At times GPs prefer holding companies longer than warranted because in some instances they can make more money from the annual management fees that they charge LPs versus selling the asset. For instance, a portfolio company value that would yield an IRR of less than 8% may be acceptable to the LP, but because it falls below the GP’s hurdle rate, it will not enable the GP to receive a carried interest. Therefore, retaining the company in the portfolio would enable the GP to continue charging the 1-2% annual management fee. Therefore, the glaring conflict of interest is that as long as the sponsor retains ownership of the companies, they can keep charging management fees which can be in the millions of dollars.
Conflict of Self-Assessment
When a Private Equity fund is relatively recent it typically contains a fair share of unrealised assets in its portfolio. When valuing unrealised assets at the end of each quarter, the GP uses estimates that follow certain industry guideline practices that have some level of flexibility. This opens it up to the possibility of GPs using comparable multiples that contribute to increasing the fund’s overall valuation which, in turn, is linked to their management fee revenue.
Investors view PE as has having less volatile valuations, which most often tends to hold true. Nevertheless, PE has issues ranging from questionable integrity around asset valuation computations to the very real conflicts that exist between GPs and LPs. To make PE worthwhile its collective peeves should be deemed less costly vis-à-vis the PE risk premium available to most long-term investors.PDF version