#Investments — 13.03.2017

Do private equity returns justify lack of liquidity and fees?

Thierry Celestin, Head of Private Equity and real-estate advisory

Private equity consists of investing in unlisted companies at different stages of their growth, with a view to optimizing their value creation by supporting their managers’ development strategy. Contrary to popular thinking, private equity is also suitable for private investors whom are seeking for a real diversification in their portfolio and potentially high returns.

Through this article, we will highlight some of the main characteristics of private equity and see whether the returns justify the lack of liquidity and fees of the asset.

The duration of private investments funds can vary significantly but is often as long as a decade or more (typically ten-year lifesplan and possibility of two or three year extensions with investor’s approvals).

Liquidity constraint tied to investments in private equity is therefore structural but allows several advantages in the management of the fund.

Private equity critics often say that, beyond these liquidity constraints, private equity funds can also charge relatively high management fees. These fees, usually higher than many mutual funds, result primarily from the high costs of thorough due diligence and monitoring on the part of the fund manager but also from the resources necessary to create value and transform private companies.

In the first years of a private equity  fund’s life, management fees are usually based on a percentage of committed capital before stepping down to a percentage of remaining capital under management after the end of the fund’s investment period.

This fee structure is meant to incentivize the fund manager to make good investments rather than rush to deploy capital to collect fees.

The following chart illustrates that management fees have remained stable over time between 1.5 and 2.0% of commitment during the investment period.

Figure 01

Source : 2016 Prequin Private Capital Fund Terms Advisor

In addition to management fees, private equity fund managers are usually entitled to receive a performance fee, known as carried interest in the private equity jargon. The carried interest is effectively a share of the profits generated by the fund, usually 20%. Nevertheless, the fund manager shall not receive this carried interest if a preferential return (calculated as a yearly internal rate of return usually set at 8%), known as the hurdle rate, is not achieved for investors.

The carried interest should be considered as the primary source of income for the fund manager and differs from management fees, which should only cover the cost of running the fund. The carried interest and the hurdle rate act as an incentive for managers to generate profit and serve to help to align managers and investors interests.

The two charts below illustrate that the current standard carried interest is 20% of profits with typically a hurdle rate of 8%:

Figure 02: Carried Interest Adopted by Direct Private Capital Funds (Funds Raising & Vintage 2015/2016 Funds Closed).

Source : 2016 Prequin Private Capital Fund Terms Advisor

Figure 03: Hurdle rate Used by Direct Private Capital Funds (Funds Raising & Vintage 2015/2016 Funds Closed).

Source : 2016 Perquin Private Capital Fund Terms Advisor

Fees should of course be evaluated closely on a case by case basis but, as the following graph shows, notably for larger size funds, they are not the most important determinant of a private equity investment decision.

Figure 04: Average Management Fee of Private Capital Funds by Fund Size and Quartile Ranking, All Vintages

Source : Prequin Private Equity Online

The tables below illustrate that private equity funds, both in the US and in Europe, have consistently over long periods over-performed the public equity markets*. (since inception net internal rate of return by vintage year)

Figure 05: US and Europe PE funds IRRs by vintage.

Source: Cambridge Associates

Europe includes developed economies only; vintage year is determined by year of fund’s first cash flow; the Cambridge Associates mPME is a proprietary private-to-public comparison methodology that evaluates what performance would have been had the dollars invested in PE been invested in public markets instead; the public index’s shares are purchased and sold according to the PE fund cash-flow schedule.

However, this exhibit also highlights wide disparities between the top performing funds (top-quartile funds) and the average of the private equity market.

“Manager selection and access to the best managers is therefore critical”

Moreover, a recent study has found a fairly high level of persistence of managers’ performance in the private equity asset class. This study divided Private Equity funds into quartiles, based on how a manager’s most recent fund performed, and examined the results for the next fund launched by each manager.

The study found that 35% of the top-quartile managers delivered top-quartile performance on their next fund, and only 13% delivered bottom-quartile results (Figure 6).

Figure 06: Private Market Persistence ? Performance often continues across vintages

Source: Steven N. Kaplan, Rebert S. Harris, Tim Jenkenson, Rudiger Stucker, “Has persistence persisted in Private Equity ? Evidence from Buyout and Venture Capital Funds (February 2014). Darden Business School paper: 2304808. Vintages are only through 2008 since more recent vintages may still be investing and have few realisations

This high persistence of performance in private equity funds confirms that there are real differences in managers’ skills and experience in creating value in the companies they acquire and manage. This reinforces our belief that proper managers’ selection and access is crucial in private equity.

To sum-up, we would argue that private equity funds performance over the years has rightly compensated investors for the illiquidity constraints and fees. This is of course even much more compelling when looking at the performance of top-quartile funds, as the dispersion of performance between top managers and the median of the asset class can be high.

It remains therefore key to have the right access and selection of top managers over time to maximise the outperformance of private equity.


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BNP Paribas Wealth Management has the means and experience to advise its private clients, offer them diversified investment strategies in the universe of unlisted instruments, and ensure efficient monitoring of their investments over time.