When the private equity business started more than 40 years ago, the average buyout boss might count his blessings if the firm could bank a fund worth, say, $100m.
These days, a hundred? Are you serious? The average self-respecting buyout chieftain will not get out of bed for much less than $5bn.
Just look at some of the best-known names in the sector. Firms such as KKR and Blackstone boast funds that have raised multiples of that figure. As for the whole industry, well, it claims to have $1.5tn in so-called “dry powder” burning a hole in its pocket. That is almost enough to buy the whole German stock market outright.
Yet there’s one thing that hasn’t changed so much: fees. The leading funds still expect to receive fixed management fees of between 1.5 and 2 per cent annually. That’s topped off with a one-fifth share in any eventual profits above a fixed hurdle rate when the assets are finally sold.
Giant pension funds may put up much of the money that buyout funds invest with. But there is little sign of them being able to extract meaningful concessions for the volumes they provide.
The result is a business that enjoys the sort of scale economies that King Croesus would have appreciated. Management fees might have originally been designed to cover the costs of the operation. Take KKR’s first fund in 1978, which raised $30m. A 2 per cent fee would throw off $600,000, or $2.7m in today’s money. Now consider that same 2 per cent levy applied to the largest fund raised to date — Blackstone’s $26bn Capital Partners VIII fund. That would chuck off $520m — or 193 times as much.
Whatever the fine print of the terms — and generally these are a closely guarded secret — it’s clear these fees have become wildly profitable. Analysis of Blackstone’s Form 10-K stock market filing for 2019 shows its buyout business made a profit margin of 45 per cent on $1.1bn of fixed revenues before any profit share.
Which all explains a new trend that sees more and more buyout firms selling off slices of that income. They package up say 20 per cent of their management fees and flog them to specialist fund managers such as Dyal Capital Partners or Goldman Sachs unit Petershill, which are (of course!) themselves investing pension fund money.
The buyers might also take a smaller slice of the “carried interest” (the one-fifth profit share) but that is just the cherry on top. What they really like is the sheer dependability of that trusty 2 per cent.
Capitalising surplus income allows the selling buyout bosses to cash in equity or raise funds for expansion without an initial public offering with all its tedious disclosure requirements.
A few more get to hoist themselves into the billionaire bracket. In an article last year, the US magazine Forbes managed to identify 13 new private equity bigshots who achieved that status by selling slices of their firms’ fees.
What is less clear though is why this is such a good deal for pension fund investors. Essentially, having over-rewarded one set of intermediaries, they are now paying another set to recoup some of their overpayment. How soon before this next layer of middlemen — the bosses of Dyal and Petershill — are themselves billionaires?
It’s also very far from the original premise of private equity. “The official story has always been we don’t make any money on management fees, we only make money on carried interest,” says the Oxford academic Ludovic Phalippou. The idea was that relying solely on the carry for profit would achieve that holiest of holy grails: the “alignment of interest” between buyout intermediaries and their investors.
It has never been easy to see how permanent capital fits into this picture. Allowing the present generation of bosses to in effect sell off rights to future income breaks the sacred principle that buyout professionals only “eat what they kill”, dulling the impulse to generate elusive “alpha”. It also encourages them simply to hoover up as many assets as possible — a practice that depresses returns.
That’s why in 2010 the academic Michael Jensen, the intellectual godfather of private equity, described a listed buyout firm as an “economic non sequitur”.
A decade on, the traditional private-equity social compact seems ever more comprehensively broken. It’s high time pension fund investors pondered the incentives they are dangling. High fees might be justified where the outcome is itself outstanding. But this orgy of extraction has been happening at a time when the returns after fees from private equity have barely exceeded those from a stock market tracker fund.
Those paying for this party should wake up and call things by their proper name. These aren’t fair rewards, they’re rents.
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