CFA Institute Journal Review April 2014 Volume 44 Issue 4
Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance (Digest Summary)
Review of Financial Studies
To determine the relationship between performance and management fees, the authors study data from 837 private equity funds from 1984 to 2010. They conclude that funds with higher costs do not produce lower overall net returns, which implies that private equity fund managers charging higher fees produce higher gross returns. Agency costs are found to still exist, however, in the form of the “waterfall effect” and in situations where funds are kept open for the purpose of collecting fees.
Private equity funds typically have a management contract that specifies the compensation structure and the ownership interest of the general partner (GP). The management fee is usually around 2%, and the typical carry charge is 20% of profits over a set threshold return. The GP usually owns 1% of the fund. The authors study how the performance of these private equity funds is related to the terms of ownership and compensation. Specifically, they examine whether private equity funds with higher fees and lower GP ownership underperform other private equity funds on a net-of-fee basis.
The authors find that the level of management fees is unrelated to net-of-fee returns. They also conclude that funds with lower GP ownership percentages do not underperform funds with higher levels of GP ownership. Several caveats to these findings are listed. First, the findings do not mean that private equity funds offer positive risk-adjusted returns. Second, the study may not include all potential fees charged by the funds. Third, agency cost issues are still embedded in private equity funds. Fourth, fees do increase during periods of high investor demand for private equity funds, but again, no relationship is found linking higher fees to lower net-of-fees returns.
According to the authors, there are instances when contract terms can lead to increased agency costs between the GP and the limited partners (LPs). The waterfall date is when funds start charging carried interest. The authors find a significant increase in distributions from investment exits in the year following the start date of carried interest. This “waterfall effect” leads to increased returns for the GP.
In addition, some private equity funds are set up to switch to a fee based on the amount of net invested capital later in the fund’s life. This provision is put in place so the LPs can avoid paying management fees to the GP for assets that are no longer being actively managed. On average, the authors find that these “zombie funds” make distributions much later than funds that maintain a more traditional fee structure. Consequently, later distribution dates lead to the LPs paying management fees over a longer period of time.
How Is This Research Useful to Practitioners?
Many investors may view private equity funds with higher fees as too expensive. The results of this study imply that funds with higher fees actually attain higher gross returns over time. These findings are in contrast to those of mutual fund research, which have shown that funds with higher fees tend to underperform similar, lower-cost funds on a net-of-fee basis. The authors also point out that investors in private equity funds still face such agency costs as the waterfall effect and management fees on inactive funds but that these costs are understood by investors and are viewed as an inevitable component of investing in this type of fund.
How Did the Authors Conduct This Research?
The authors use a proprietary dataset provided by an institutional investor that is active in private equity funds. The dataset includes 837 anonymous buyout and venture capital funds, representing approximately $600 billion in committed capital. The funds were started between 1984 and 2009. Data collected include management fees, carried interest charges, and GP ownership amounts for each fund. Returns are based on quarterly cash flows and on estimated quarterly market valuations. The authors use these data to examine the relationship between the contractual terms of the private equity investments and subsequent net-of-fee performance.
This research is noteworthy because of the unique and comprehensive dataset. I am surprised by the difference between the results of this study and those of similar studies previously conducted on mutual funds. These results appear to imply that institutional investors in private equity funds are getting what they pay for but need to be aware of agency costs—namely, the waterfall effect and management fees on inactive funds.