Private Equity Firms Get Creative with Fees

Alternative carry structures, lower management fees, and early bird discounts are among the ways private equity shops are luring in allocators.

Victor J. Blue/Bloomberg

Victor J. Blue/Bloomberg

Private-equity firms are resorting to tried and true sales tactics to encourage investors to allocate capital to their funds.

Foremost, they are changing up their fees.

The two percent management fee is “no longer the gold standard” when it comes to private equity firms, according to a survey report released Monday by asset management advisor MJ Hudson’s limited partners unit. Instead, companies are offering things like early bird discounts or waterfall structures that prioritize certain groups of limited partners based on their involvement with the general partners.

This shift comes as capital continues to pile into private equity. As managers search for ways to sustain inflows amid rising competition, bringing down fees and offering special terms help them stand out to potential investors.

“The majority of capital under management commands a 1.5 percent fee — this can be ascribed to the ‘mega-funds’ effect, whereby managers raising multi-billion funds can afford to lower their fees, as the absolute amounts charged run into the high millions,” according to MJ Hudson.

However, it’s important to note that a greater number of firms reported offering a 1.76 to 2 percent management fee (42 percent of respondents) than said they charged 1.5 percent (19 percent).

Allocators remained broadly unhappy with private equity management fees at the end of 2017, according to new research from data provider Preqin. Six in ten investors (64 percent) cited these fees as the top way to aid alignment between limited partners and general partners. “Management fees and transparency are the key areas in which LPs believe alignment of interests can be improved,” according to Preqin, which noted that these haven’t changed since the 2016 survey.

[II Deep Dive: Fees Have Declined But Are Still High]

In addition to edging down their management fees, some firms are offering incentives to spur LP activity. According to MJ Hudson, 24 percent of survey respondents said they would offer discounts on headline fees for allocators who invest early or commit a large amount of capital.

Where managers showed less flexibility is performance fees. According to MJ Hudson, 85 percent of survey respondents in 2018 said they charge a carried interest rate of 20 percent — almost unchanged from the 87.5 percent who said so in 2017. “Although a 20 percent share of a fund’s profits remains the market rate for carried interest, the trend to offer carried interest innovations continues from last year,” the report stated. Variations encountered over the past year included deal-by-deal performance fee structures, dual waterfall arrangements, and ratchet-based carry.