By: Konstantin Danilov, AllAboutAlpha.com Editorial Board.

Private equity funds can bring many valuable qualities to a portfolio.  But critics of the asset class  sometimes charge that its defining characteristic is its high fees and relatively low performance.   Yet investors continue to invest in new funds. Is it possible that some investors are “fooled” into investing in buyout funds?  This is the question posed by Ludovic Phalippou of the University of Amsterdam in a new paper called “Beware of Venturing into Private Equity”.  Phalippou focuses his critique on buy-out funds.

Fee-for-all

He cites two studies to show that after fees, the average buyout fund underperforms the S&P 500 Index; however, gross-of-fees, the average fund is able to outperform.   So how much does it really cost to invest in a buyout fund?

Using a proprietary collection of fund-raising prospectuses, Phalippou dissects the key compensation terms for a typical fund:

• Management Fee – annual fee, typically 2 percent of the capital committed until the end of the five year investment period, at which point it is applied invested capital only.
• Carried Interest – annual incentive fee that is based on the returns earned by the fund, given that a hurdle rate of 8% is met.
• Portfolio Company Fees – fees taken directly from portfolio companies that include: transaction fees; termination fees; legal and accounting fees; monitoring fees; and director fees.  Contracts typically do not specify the level or timing of fees, despite the fact that these fees can account for as much as one-third of all fees charged by the fund. A portion of these fees are rebated to LPs, although actual amounts differ vastly between funds.

Using figures that are representative of fund performance, Phalippou calculates the fee amount charged as an annual percentage of the invested amount – or, the equivalent amount an equity mutual fund would have to charge to collect the same amount of fees. That amount comes out to a staggering 7% per year, which appears excessive – especially for an investment that underperforms the S&P 500.

A Small Misunderstanding…

Despite less-than-stellar performance and apparently egregious fees, buyout funds appear to have no problem attracting investors.  The two potential reasons behind this phenomenon appear to be 1) minor differences in opaque fee contracts that lead to disproportionally larger fees and 2) exaggerated performance figures.

Effective management fees, for example, can be significantly higher than the nominal 2% fee stated in the contract. Because funds typically levy the fee on the amount of capital committed – but not actually invested – the effective fee (i.e. the amount charged relative to the amount actually invested) can vary substantially across funds; it depends on how much of the committed capital is actually invested.

Carried interest calculations create even greater levels of variance in paid fees, despite the fact that most funds do not deviate from the 20% of profits with an 8% hurdle rate structure. Portfolio company fees are not specified in advance, despite the fact that it appears that these levels vary greatly across funds. Further, some firms even deny investor requests for records of previously charged fees that can be used to estimate future fees. Because of the hidden complexity of the fee contracts, investors will often have great difficulty comparing contracts and anticipating future fee payments.

On the other hand, inflated performance figures often result from various reporting problems; lack of reporting of negative IRRs for low multiples (see chart below), overvaluing poorly performing investments, using IRR flaws to improve performance, and sample bias often lead to inflated performance. Lack of detail in fundraising prospectuses further compounds the problem; for example, omission of the relevant time periods and leverage levels make the reported multiples difficult to gauge.

Not Smart Enough for Their Own Good?

Phalippou reaches the conclusion that investors continue to invest in buyout funds because of a combination of a) the high level of complexity of the information regarding fees and performance and b) a lack of expertise on the part of some investors. The fact that funds often refuse to provide additional information to smaller investors further compounds the problem, making learning from past experience or comparing fee structures between funds extremely difficult. It seems that some investors are indeed “fooled” into investing in new funds.

Even if the flaws Phalippou discusses are eventually corrected, other factors may allow the “low-performance-high-fees” phenomenon to persist. Overconfidence and herding biases are surely as rampant in private equity investing as they are in traditional equity markets. And because no passive investment alternative for private equity exists means that investors have little choice but to continue writing hefty fee checks to fund managers. Lastly, because funds don’t compete on the basis of cost – performance is the main product differentiator – there is little hope that, at some point, increased competition will drive down fees.