The concept of 2 and 20 and whether it’s worth it for parking vast sums of money in alternative investments is as old as the concept of alternative investments itself.
So it’s not much of a surprise that Preqin’s latest report on infrastructure-focused funds (click here to download the report; click here to download the press release) finds that a strong majority of investors think the fees are for the birds. Of surprise, however, is that it’s not the ’20’ that anyone is seemingly arguing with, but rather the ‘2’.
Almost two-thirds of investors surveyed in its latest report believe that management fees on infrastructure funds should be better aligned with what is provided – not performance fees, which typically come after a manager hits or surpasses their high water mark, but the percentage collected to keep the lights on and computers running.
Indeed, management fees and carry structures are the areas where there is the most dissatisfaction; according to Preqin, 62% and 53% of investors cited each area respectively, while 56% take issue with paying fees on un-invested capital and 42% are unhappy with hurdle rates (see chart below).
For private equity in general, it’s a contentious issue – for the simple reason that much of what is being invested isn’t always being put to work. Unlike hedge funds and other types of pooled investments, the management fee is part of the broader cost of buying, selling, researching and analyzing ongoing investments, typically in different types of securities.
Infrastructure funds, like many other types of private equity funds, tend to focus much more on longer-term capital and bricks-and-mortar-type deals, which in turn means money left on the sidelines as deals are explored and pondered.
But as one private equity investor pointedly put it at a recent conference: “When we have money in funds that isn’t being invested in deals but waiting as commitments to be drawn down, why am I paying 2% in management fees?”
It’s better than it used to be. Frustration with management fees has declined since 2010 when 72% believed them problematic. Meanwhile, investors are increasingly satisfied with the interaction they have with their managers; the proportion that stated there needed to be an improvement fell by 12 percentage points from 2010 levels to 13%.
While a little more than half of the investors interviewed believe that interests between fund managers and investors are still not properly aligned, Preqin noted that that’s still an improvement from the 72% who believed the same in June 2010. In the same vein, while 28% felt that fund managers need to make greater contributions to their own funds, that’s down dramatically from almost half (45%) in 2010.
Kudos to Preqin for trying to put a positive spin on things, though the report also notes that 70% of investors are planning to make further commitments to infrastructure funds in the next 12 months.
For managers of hedge funds, private equity and other strategies deemed non-conventional, the straightforward premise is that the knowledge, expertise, due diligence and sophistication they provide comes with a price tag. For investors, it’s long been that the price paid can and should equate to what they get for it: positive, long-standing returns that beat everything else.
Which raises another point: the potential for very high returns is typically lower in infrastructure; only 1% of infrastructure funds are targeting an IRR of over 25%, Preqin notes, explaining why the majority of infrastructure investors believe management fees should reflect this lower risk/return profile.
Preqin notes that the median average management fee did fall post 2008, dropping as low as 1.63%. But the following year it crept back up to 1.75%, stayed there in 2010, and this year, has risen again to 2% – the same level as in 2007.
To be sure, some large private equity shops like KKR and Blackstone (now StonePeak Infrastructure Partners) have publicly lowered their management fees to attract investor capital, and many fund managers also have structures in place to reduce the management fee charged in different circumstances, such as in return for a higher level of commitment from the LP, notes Preqin.
Still, there’s a reason the adage “you get what you pay for” will never go away, particularly in the alternative investment world: because there will always be someone on one side of the counter that thinks they can get the same thing or better for a lower price.