A client reputedly asked Wall Street legend John Pierpont Morgan “where are the customers’ yachts?” during a stroll round a harbour jammed with fellow bankers’ leisure craft. Buyout bosses face similar questions from their own investors. Private jet flights are among the expenses some private equity executives have charged to customers alongside standard fees.
Gary Gensler, head of the US Securities Exchange Commission, has promised to let hygienic sunshine in on this tangled mess. Some external investors known as “limited partners” are disgruntled with the practices of buyout groups and their bosses — “general partners” in the jargon.
Gensler should be able to deal with one element of the row — transparency — relatively easily. He would struggle to do much about the quantum of fees charged by private equity groups. This is a function of their market power, which is cyclically high in line with asset markets.
First, we need to recollect how buyout groups, such as KKR, Blackstone and Carlyle, bill for their services. Investors typically pay an annual management fee of 1 to 2 per cent. They are also subject to a performance fee of 15 to 20 per cent. This cuts in on a sliding scale once a hurdle rate of 8 per cent has been exceeded.
There are a further 10 broad categories of charges which limited partners may be liable for, either directly or levied on investee businesses, according to StepStone, a private markets business. These include deal costs, and more vaguely, “monitoring”. “Private equity fees are like snowflakes: abundant, unique and lacking in transparency,” StepStone drily writes.
Buyout groups sometimes discount annual management fees in proportion to one-off charges. Their investors have greater grounds for complaint when costs are simply lumped on top.
The negotiating position of buyout groups is bolstered by the eagerness of limited partners to invest. By the end of the third quarter, private equity had raised more than $500bn worldwide, putting the industry on course for a record year. Clients have been undaunted by independent estimates suggesting that returns net of fees are no better than the stock market.
The tone for fee negotiations was set in 2016 when Advent International dispensed with the traditional 8 per cent hurdle rate on a $20bn fund. The US group replaced this with a softer so-called “value test” on net assets.
That at least appeared to apply to all investors. But private equity investors may also be subject to different charges from the same manager without knowing it. Buyout bosses may even talk them into waiving fiduciary duty rights.
This would make perfect sense to a Wall Street lawyer. Simple folk like me find it harder to understand exceptions to the general client relations rule: “do the right thing”. Gensler needs to assert the overriding character of an asset manager’s duty to act in all clients’ financial interests.
Tax creates further disparities. A tax-exempt pension fund reaps a special financial gain when the buyout group charges it lower management fees while loading costs on to the investee company. That business, which they both own, thereby benefits from a tax deduction, points out Ludovic Phalippou of Oxford’s Saïd Business School. Big pension funds such as the California Public Employees’ Retirement System are typically able to negotiate fees far lower than smaller investors.
Private equity bosses bridle at the idea of one-size-fits-all fees. Discounts for bulk, they say, are a feature of transactions as disparate as floating businesses on the stock market or buying canned drinks in a store. It is harder for them to argue against schedules of fees that are clearly disclosed to investors up front. This is the tack Gensler should pursue.
Transparency encourages standardisation and drives down prices. Sheer cyclicality is likely to have the same result. Anticipated interest rate rises have increased the chances of a correction in asset prices. Buyout groups would then have to mark down portfolios, absorb losses on exuberant bets and rein in their demands.
But the industry would settle at a far higher level than after its last setback in the wake of the financial crisis. Some pundits demonise private equity as exploitative. A dispassionate view is that it is the product of public market failure, combined with the privileged tax status of debt over equity and of capital gains over income. It will persist while those conditions do. Maturity brings responsibilities, on jet flights, disclosure and much else besides.