As firms increasingly prepare for retail flows into alternative investments, private equity (PE) fees have once again captured headlines. This renewed interest arises from PE firms’ ambitions to have a place in defined contribution (DC) retirement plans, with the backdrop of the Securities and Exchange Commission (SEC) being renowned for prioritizing the protection of retail investors.
According to Preqin’s 2021 Global Private Equity Report, over 18,000 private equity funds exist today with assets under management surpassing $4.7 trillion. Even amidst challenging fundraising circumstances, private equity AUM maintains a steady growth trajectory, with Preqin projecting it to reach $7.6 trillion by 2027.
The New SEC Rules
Yesterday the SEC unveiled what many anticipated to be the most significant private equity regulation in decades. Initiated 18 months prior for public comment, these rules aim to infuse greater transparency and competition into the expansive $25 trillion private funds industry. SEC Chair Gary Gensler emphasized his mission to reduce fees and expenses, which he calculates cost investors hundreds of billions of dollars annually.
However, the regulation, as finalized, was significantly diminished from the original proposal.
The new rules do mandate registered private funds to issue quarterly financial statements to investors, including detailing fees, and also necessitate annual financial statement audits.
Despite the reinforcement in the above areas, the SEC diluted many initial provisions. For instance:
- No alterations were made to private fund liability rules, which would have facilitated LPs ability to sue GPs.
- The initially proposed ban on “fees for unperformed services,” like accelerated monitoring fees, has been omitted.
- Funds can still bill LPs for regulatory or compliance-related fees, provided they’re transparently disclosed.
Private Equity’s Appeal to Retail Investors
Advocates argue all well-formulated investment portfolios should have an allocation to private equity. After all, institutional investors have invested in PE for decades.
Yet, are the renowned benefits of PE, such as robust returns, diversification, and minimized drawdowns, becoming somewhat illusory in our current environment?
Returns: PE’s historical outperformance is undeniable. However, has recent outperformance persisted?
According to a study titled “Should Defined Contribution Plans Include Private Equity Investments?” published in the Q4 2022 Financial Analysts Journal, buyout fund returns over extended periods (15-, 20-, 25-year horizons) surpassed public benchmarks by approximately 2-4 percentage points annually. However, recent 5- and 10-year performance fell behind the leveraged benchmark. This observation aligns with other contemporary research on average PE performance persistence.
Diversification: The public markets have constricted over time, especially small-cap value stocks, a favorite among many PE funds. Factors like the Sarbanes-Oxley Act of 2002, which escalated public company costs, and a decline in the number of public entities compared to two decades ago, escalated the trend. So arguably, accessing this part of the market can best be accomplished via investing in a PE fund.
Nevertheless, the Man Institute suggests a substantial 75.7 percent correlation between PE and public equity market returns, casting doubt on PE’s diversification potential.
An emerging trend worth noting is the rise of growth equity PE funds. These funds, emphasizing sectors like healthcare and technology, offer potentially higher returns despite increased risks.
Lack of deep drawdowns: Astute investors recognize the capacity of PE firms to modulate returns. While having smoother returns over time rather than booking a large quarterly loss can be enticing, it can also veil certain practices. For instance, in-house valuation work provides managerial discretion over assumptions, potentially inflating illiquid portfolio company valuations. And practices like borrowing money to initiate deals instead of calling for initial investor capital can inflate the fund’s stated internal rate of return, a phenomenon AQR Capital Management’s Cliff Asness terms “volatility laundering.”
For example, a Q3 2022 survey by investment bank Lincoln International showed PE firms reporting a year-to-date 3.2 percent increase in their portfolio companies’ value, in stark contrast to the S&P 500’s 22.3 percent decline.
Concerns Over Private Equity Fees
Fees remain a central concern. A recent survey by Richard Ennis for the fiscal year ending June 30, 2021, encompassing 59 public pension funds (often the most transparent regarding fees), found PE allocation fees averaging about 5 percent. This aligns with typical institutional pricing structures of slightly below 2 percent management fees and slightly below 20 percent incentive fees in a mid-teens return environment.
However, there’s increasing scrutiny as many PE firms introduce additional layers of fees in the form of fund expenses, such as charges for portfolio company “monitoring,” acquisition “transaction fees,” and operational recommendation “advisory fees.”
Conclusion
While the historical strength of PE remains undeniable, its allure seems diminished in the current investment climate. The hefty PE fees and fund expenses, combined with potential retail marketing wrappers, present substantial barriers for retail investors hoping for returns. And certainly investing with “the best” makes a difference in private equity, as in all alternative investing. Given these complexities, it’s hardly surprising that SEC Chairman Gary Gensler perceives private equity in its current format as intricate and potentially perilous for the average investor.
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