Private Equity Hidden Fees Cost Investors $20 Billion here is the study H/T Simon Clark of WSJ

Ludovic Phalippou

University of Oxford – Said Business School; University of Oxford – Oxford-Man Institute of Quantitative Finance

August 6, 2015

Abstract:

Investors in private equity funds make payments for fund management fees and for fund investments; they receive capital which comes from the sale of these investments and that capital is net of carried interest. The carried interest is non-zero if the fund has returned sufficient capital back to the investor (and is zero otherwise). The calculation of the carried interest is complex and investors usually do not track the total amount of carried interest accrued. This means that investors cannot have a historical and comprehensive perspective on carried interest. However, because carried interest is paid only if performance is good, it is commonly thought that tracking carried interest does not matter anyway. Yet, because this fee is non-linear and investors have a portfolio of funds, significant carried interest can be paid even when the private equity portfolio has shown poor performance. This means that tracking carried interest is economically useful. Data from three large US pension funds is used to illustrate. Statistics are remarkably similar across these investors. Estimated carried interest is about $5 billion, which represents about 13% of capital invested, 19% of overall profit and 38% of profits above a standard benchmark (8% per annum over four year). Given past performance, past carried interest paid does not appear to be a major issue. Yet, the conclusion depends on the benchmark used, the estimated absolute amount of carried interest is significant, and if future performance differs from past performance, the way carried interest is currently computed could be problematic for investors going forward.

A Note On Carried Interest In Private Equity – Introduction

Investors in private equity funds make payments for fund management fees and for fund investments; they receive capital which comes from the sale of the fund investments and that capital is net of carried interest. The carried interest is a performance based fee; it is non-zero if the fund has returned sufficient capital back to the investor (and is zero otherwise). The calculation of the carried interest can be quite complex (see appendix). Yet we can obtain a ballpark number – as we do below.

There has been some confusion recently on carried interest, which we hope to dissipate in this note. Below is an extract from a memo by Pension Consulting Alliance (PCA) dated July 2015. PCA is a consultant specializing in private equity investing for pension funds. The arguments are representative of those of the private equity industry:

“The accounting profession and most investors consider carried interest to be an allocation of profits between/among partners in a fund, not as an expense as it has been characterized in recent reports and articles. This has caused confusion and added to the lack of clarity in the discussion (…)

Most investors have historically concluded that the aggregation and reporting of a manager’s share of profits was unnecessary for those with plan sponsor fiduciary responsibility. Historically there has been almost no public reporting of a general partner’s profit allocation by its investors (…)

Lastly, it is worth mentioning private equity’s role as a return enhancing asset class in an institutional investor’s portfolio (…) As of March 31, 2015, the portfolios comprising the peer-based State Street Private Equity Index reported annual returns of 11.5% over the last ten years, compared with 8.4% generated by the Russell 3000. A continuation of private equity’s outperformance relative to the public markets is necessary for many investors to continue meeting their objectives.”

The first point in this memo basically says that carried interest is not a fee and that seems to explain why investors have not tracked it. As shown below, we estimate that CalPERS investments generated $5.3 billion in carried interest. If the carried interest rate would have been 10% instead of 20%, the amount would be $2.3 billion, and CalPERS would have $3 billion extra on its account. If the carry rate would have been 20% but the so-called catch-up rate had been 0% instead of 100% (the latter being standard, see below and appendix), then the carried interest would have been $2.9 billion and CalPERS would have saved $2.4 billion. Hence the way the carried interest is calculated changes significantly the amount of money that CalPERS earns. It is hard not to think of this as fitting the definition of a fee.

Under U.S. GAAP, the cost of carry is indeed not treated as either an expense to the fund or an expense to the limited partner investors. Most likely, the people who are making this ‘accounting’ argument are attempting to use this statement about accounting to imply that the limited partners should not concern themselves with the amount of carry they pay because it is “not an expense” from an accounting point of view. Hence, carry paid is not an expense to limited partner investors or the fund under U.S. GAAP, but that it is clearly an economic cost to the fund and, ultimately, investors and that is why it should be treated as such by investors.

The last point of PCA on performance will be tackled at the end of this note after we discuss carried interest and why it matters in more details.

Investors usually do not verify whether carried interest is computed correctly or not themselves. The carried interest is already deducted from the payments they receive. They have to rely on the fund auditors. In fact, as mentioned above, investors often do not even track the total amount of carried interest paid in each fund. To track it they would need to obtain and collate the information from each of the fund managers every quarter or year. Pensions funds often hold over one hundred funds. CalPERS for example is currently invested in 274 private equity funds. Collating such a large amount of data is therefore not trivial and costly. In addition, CalPERS has recently reported that a minority of GPs are not even willing to provide this piece of information.

In addition, because carried interest is paid only if performance is good, it is commonly thought that tracking carried interest is not important: in a way, the more carry has been paid the better for the investor. However, and importantly, because the fee is non-linear (i.e. paid only when performance is above a certain hurdle and zero otherwise) and investors have a portfolio of funds, significant carried interest can be paid even when the private equity portfolio has shown poor performance.

Take an investor who invested equally into two funds. Fund A returns 10% before carried interest is charged while Fund B returns -18%. Carried interest of about 2% would be paid on fund A, nothing on fund B. This investor would have an average return after carried interest of -5% and have paid a total of 2% in carried interest. Generally, if there are a few well performing funds and many badly performing funds then a lot of carried interest is paid despite poor overall performance. In fact, carried interest may be more than 20% of the profits generated by a

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