Why Gross – And Not Net – Returns Matter

It’s time for asset owners to act like owners, and stop private equity managers from extracting excess value through complex and lofty fee arrangements.


With the leaking of private equity limited partnership agreements in Pennsylvania and the ongoing SEC investigation into hedge fund and private equity fees, it would seem that attention is finally being paid to the cost of external asset management. The PE industry is trying to keep its cool with a “nothing to see here” attitude, but it’s hard not to view some of the recent revelations as “a seismic event for the private equity industry.” Some people are even referring to this as the “Snowden Moment” for the focus on secrecy and non-transparency within the PE industry:

“It was a self-serving ploy to shield the documents from scrutiny, since third parties might ferret out how private equity firms increase their already substantial profits at the expense of compliant, clueless investors.”

In my view, the investors in these PE funds often pensions, endowments and charities should take advantage of this moment to push back against the fee machine.

For too long the asset owners have allowed asset managers to get away with too much. I can think of one executive of a large asset owner that literally told a senior investment officer to “stand down” on the fee and cost issue for fear of alerting the board and the sponsor to the issue. I can also think of organizations that present incomplete fee pictures in their annual reports: Some funds focus only on base fees and bury performance fees in net return numbers, while others make no attempt to quantify the implicit fees associated with holding, moving or trading assets (despite the fact that the implicit numbers, such as spreads and transaction costs, can be very high).

As such, while it may annoy the constituency I personally want to serve and empower, I agree with Dan Primack ”... the victim is complicit by virtue of not paying attention.

Undoubtedly, it will be harder to ignore the issue going forward. But to ensure that this issue is taken more seriously, I’d like to offer some explanations as to: 1) Why fees are often left as an afterthought in the institutional investment business; and 2) Why it’s in the interest of asset owners to pay more attention.

1) How We Got Here: I’ve discussed this issue at length in past posts, so I’ll refrain from going too deep here. But what I will say is that it’s not unsurprising that asset owners would have little interest in the fee issue:

- Path Dependence: The traditional institutional investor was almost entirely outsourced, rarely possessing the expertise and competencies to execute even the most basic financial transactions without the help of some external advisor. This model worked for a while, thanks in particular to a series of bull markets. However, over time, the extended chain of principal-agent relationships became problematic. In particular, the rising complexity of finance and investment put a severe strain on the boards of these funds to comprehend the risks and, as a consequence, the costs of the products they were consuming.

- Performance Drivers: Among the big asset owners, it’s a commonly held investment belief that asset allocation drives over 90 percent of the return. (The truth is more nuanced, as the return variation to asset allocation is lower than many realize and active management does play a role). Compared with asset allocation (so the investment belief goes), the selection of instruments and investment vehicles has a minor impact on overall performance. However, asset allocation has little impact on fees; it’s the choice of instrument that has a big impact. As such, the priorities of senior investment staff are on the areas where fees aren’t accumulating.

- Overconfidence: I’d also suggest that many large asset owners suffer from an over-confidence bias, nurtured by insufficient information and lack of appreciation for how costs migrate within mandates and across the entire portfolio. (You can be sure that the intermediaries are going to work hard to get their margins; the financial services industry isnt getting over a third of all corporate profits in the U.S. of A. by allowing pension funds to plug the leaks.) And the asymmetry of information that the financial providers have over the asset owners makes it relatively simple to do so.

2) Why Fees Matter: This issues goes way beyond just fees and costs for me. I think asset owners — and indeed the system of capitalism — would be well served by focusing like a laser on the fees paid to these service providers. Heres why:

- Scale: The high fees paid to the financial services industry have allowed it to consolidate power and then wield that power to extract a disproportionate share of value out of the global economic system. Think of it this way: Paying overly generous fees today is a recipe for paying even higher fees in the future. We need to rip that band-aid right off.

- Resourcing: If a board — let alone the sponsor or general public — understood the true cost of running a pension fund, it would result in the board making some different resourcing decisions with respect to its internal investment team. I believe asset owners would undergo a massive wave of professionalization, which would result in these owners actually acting like owners. And that would be a very good thing.

- Innovation: Cost and fee transparency would be a catalyst for innovation and change within the overall pension organization. Once a fund becomes professionalized, a world of new opportunities can arise for these organizations. For example, pensions have the ability to invest across silos and take advantage of their broad market purview to generate returns in a variety of different pockets; managers operating in well-defined silos do not. Heres a simple example: The infrastructure team of a pension is financing a new bridge; the real estate team is buying up property at the other side of the bridge to take advantage of real estate values going up; the fixed income team is investing in the project bonds, while the equity team is taking up the rights issue by the company that will actually build the bridge. A single fund operating in a silo could never do this, but a big pension fund could. And one already has come close.

-Risk: Fee structures have the potential to dampen the volatility (risk) of certain asset classes, which means that asset owners often misunderstand or simply dont know their risk exposure. Is a university endowment with 80 percent allocated to alternative asset managers doing a good job if it generates 10 percent returns? Here’s a better question: How much return is it generating per unit of risk? I’d wager most have no clue, and the reason is that they don’t know how much risk their external managers are actually taking.

-Sustainability: Because the fee issue gets hidden in many models of institutional investment (but especially in the Endowment Model), many asset owners (wrongly) think that the best value comes from working through superstar external managers. But this focus on third-party intermediaries results in an orientation toward short-term financial performance that only serves the financial services industry. I’ve said it before, but I think long-term investors today have given up their long-term competitive advantage on the altar of alpha. And thats very bad for the long-term issues that matter for long-term economic growth.

- Risk-free Returns: In a low return environment, saving basis points actually does matter (especially when compounded over years to come). I can’t think of anything else an investor can do to generate risk-free returns than get a cheaper access point to the same risk exposure. Can you?

In sum, it just makes sense that the big asset owners would look to take on the issue of fees and costs with a vengeance. I do recognize, however, that many of the people working in these funds are very happy with the status quo. They prefer to avoid career risk by shifting investment risk to others. But I warn you that the reputation risk associated with this path is growing. Do you want to explain to your pension or sovereign fund sponsors — let alone the general public — that your lack of attention allowed the private industry to accumulate wealth beyond anything remotely reasonable? That your oversight — the board; the management — has been complicit and even instrumental in allowing most if not all of the scale economies to accrue to the private managers? Not me.