What makes financial capitalism so compelling is the idea that modern fund managers fully participate to the upside of their investment decisions with little exposure to the downside. This “Heads I Win, Tails You Lose” model helps maximize the economics of the trade.
Certainly, private capital firms accumulate wealth regardless of the underlying portfolio’s risk–return trade-off. To recap, the performance of alternative asset managers is encapsulated in the following formula:
Wealth = Controls + Economics
We explored the techniques managers use to control investment outcomes in Part 1. Here, we outline the second component of the wealth equation: economics.
Offloading Investment Risk
How to diversify risk away is a vital piece of the economics puzzle for alternative managers. One way to accomplish this works like a game of roulette: The more numbers you bet on, the better your chances of winning. To improve their odds of making money, fund managers often invest in many corporations or start-ups that compete in the same sector.
But the genius of alternative investments is that fund managers’ share of losses is restricted to only the portion of their annual bonuses — derived from annual management fees charged on their clients’ capital commitments — that they co-invest alongside their clients. This token participation gives the appearance of skin in the game and aligned interests, but the managers’ odds are much better than those of their LP investors: It works as a sort of call option that fund managers can exercise if the value of the portfolio asset rises or let expire if the value falls. The symbolic co-investment acts as an option premium.
Another way private equity (PE) firms can tilt the balance in their favor is to finance buyouts with leverage. Higher leverage has the mechanical effect of lifting the internal rate of return (IRR), providing a shortcut to beat the hurdle rate. Of course, excess leverage amplifies the financial stress on the borrower and increases the likelihood of default. This, in turn, can lead creditors to seek control of the portfolio asset and provoke heavy capital losses for the fund managers’ clients. But as agents, the fund managers themselves simply lose out on future fee income.
Management, Not Ownership
Capitalism has moved away from its classical definition. It no longer depends on ownership rights and private property but on management rights and controls. We own our pension plans and other financial assets. But in Marxian terms, we are nonetheless “alienated” from them when we outsource their administration.
Asset custody is indeed more relevant than ownership. The transfer of property rights doesn’t affect the fund managers’ ability to levy fees on capital commitments. These financial intermediaries have the “right to use” rather than the “right to own” their clients’ assets.
The ingenuity of the custodial investment model is that, unlike banks and other traditional financial institutions, alternative managers do not pay for the privilege of administering other people’s money. Instead, they earn an abundance of fees, often irrespective of performance.
The main consideration of the economics variable is, therefore, rent extraction engineered through quasi-unqualified, long-term contractual access to assets without being charged by the captive, fee-paying asset owners. Customary money management techniques, in contrast, rely on dividends and capital gains derived from equity instruments, or interest payments and coupons received from loans and bonds.
The alternative fund manager’s fee-based model takes three tacks: First, annual management commissions (AMCs) can range from 1% to 2% of assets under management (AUMs) in PE and private debt (PD), and exceed 2.5% in smaller funds, particularly in venture capital (VC).
What is most striking is how large management firms can keep drawing out AMCs in excess of 1%. Apollo Global Management, for instance, reaped “1.5% per annum of [its] Fund VIII Capital Commitments up to $7 billion, and . . . 1.0% per annum in excess of $7 billion,” according to the limited partnership agreement. Yet mega buyouts do not require proportionally higher involvement than mid-sized ones. At any rate, operational work is charged out separately in the form of advisory fees.
But management commissions explain only part of the alternatives model’s profitability story. (Although some managers rely on them more than others. For example, over 80% of Bridgepoint’s operating income from 2018 to 2020 was from AMCs.) To complement their revenue stream, fund managers solicit performance fees — also called carried interest, or carry — which grant them the right to capital gains above a certain rate of return guaranteed to investors. This share of the upside varies widely: In PD, it is typically set at 10%; in PE, it is closer to 20%; for the most prestigious VC fund managers, it can exceed 30%.
Importantly, the carry agreement never requires fund managers to share in the fund providers’ capital losses. This is a cornerstone of the private capital wealth equation. Besides, the guaranteed or preferred rate of return — the hurdle rate — is usually set at 8%, but managers with market power can negotiate much lower hurdle rates or forgo them altogether. KKR, for instance, raised two European PE funds in 2005 and 2008 without offering clients a hurdle rate, though it reversed course for its third European vintage in 2014.
Finally, exceeding the hurdle rate is challenging. This makes carried interest neither dependable nor sufficient as a revenue source. For example, carry contributed only 5% to Bridgepoint’s operating income in the three years from 2018 to 2020. For that reason, ancillary charges can help top up earnings. Some of these are advisory in nature, such as monitoring, consulting, or director fees. Others have more prosaic labels, including completion, syndication, arrangement, or break-up fees. Many fund managers eventually return part or all of these advisory fees to their LPs.
This fee-centric money machine relies on inertia: Because of a severe lack of liquidity, private capital firms will often hold onto assets through market downturns without facing the risk of redemption that afflicts hedge funds and open-ended mutual funds. Loose mark-to-market rules can conceal the true extent of value erosion, so these firms can keep collecting fees.
Moreover, private markets are essentially transactional. Buyout and credit fund managers, in particular, can exact additional compensation with every corporate event. Dividend recapitalizations, refinancings, bolt-on acquisitions, loan defaults, equity cures, amend & extend procedures, equity swaps, or any other activity that requires the expertise of financial sponsors and lenders justifies a little stipend in exchange for their consent to rearrange the capital structure.
The terms and conditions of these commissions are important attributes of the economics variable. Once fund managers have exclusive control of these assets, new streams of income become easier to engineer. In fact, LP investors may not always understand the various reward mechanisms available to their fund managers.
This opacity can lead to hidden fees and other expenses since investors often lack the authority and wherewithal to independently audit and investigate the fund managers’ activities. Some of the largest global private capital firms have faced allegations of overcharging in recent years and reached settlements with the SEC: Apollo paid $53 million for misleading disclosures, Blackstone $39 million for disclosure failures, KKR $30 million for misallocating expenses related to failed buyout bids, and TPG Partners $13 million for failure to disclose the acceleration of monitoring fees to its LPs.
The unconditional control fund managers exercise over both their AUMs and portfolio companies contributes to the solicitation of such financial tributes. No wonder some institutional investors have called for “absolute transparency” in private market fees.
Hidden fees are a form of stealth tax, but the alternative management model operates in plain sight. The commissions charged by money managers are reminiscent of the tithes once levied by the church and clergy. Those required 10% of the subject’s annual produce and income.
Today’s PE firms earn combined fees — management, performance, advisory, and other ancillaries — on the proceeds distributed to LPs that often exceed that 10% annual threshold. In reference to an investment firm’s asset base rather than often-illusory capital gains, total fees can add up to 6% a year.
Already 85% of US public pension funds invest in PE. Privately managed plans are expected to follow suit. Individuals can now directly invest in alternatives through their 401(k) plans. After years of lobbying by the private capital industry, more and more investors are becoming “tithable.” Free access to third-party money has heralded the age of permanent capital and perpetual fee generation.
In private markets, long-term commitments provide a sticky offer and higher customer lifetime value. This leads to a recurring flow of income and better economics than other asset classes. By charging commissions for fundraising and asset management, as well as portfolio realizations, monitoring, and restructuring, private capital firms receive a cut at every step of the value chain. From the fund managers’ standpoint, that makes for a flawless business model for wealth-maximization purposes.
Although alternative products accounted for less than 10% and approximately 17% of the global fund industry’s total AUMs in 2003 and 2020, respectively, they delivered around one-quarter and more than two-fifths of revenues in those same two years.
“The yield business is a scale business,” Apollo CEO Marc Rowan said. More accurately, fee structures and control rights, rather than the depth of the asset pool, spice up the recipe for private market success. Without greater regulatory oversight or increased bargaining power among LP investors, the sinecure is sure to endure.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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Sebastien Canderle is a private capital advisor. He has worked as an investment executive for multiple fund managers. He is the author of several books, including The Debt Trap and The Good, the Bad and the Ugly of Private Equity. Canderle also lectures on alternative investments at business schools. He is a fellow of the Institute of Chartered Accountants in England and Wales and holds an MBA from The Wharton School.