Do private equity returns justify lack of liquidity and fees?

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.

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%:

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.

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)

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

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).

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.