The 2 percent management fee that has been the industry benchmark for leveraged buyout funds since the 1970s is headed for extinction.
The California Public Employees’ Retirement System, the biggest U.S. public pension plan, AlpInvest Partners NV, Europe’s largest backer of private equity funds, and HarbourVest Partners LLC, which has more than $10 billion in LBO funds, are pressing firms to cut their rates.
“We should be able to get a better deal from private- equity firms in this market,” said George R. Anson, managing director at Boston-based HarbourVest.
Buyout firms recorded a 31 percent decline in the value of their holdings last year, the biggest drop since London-based research firm Preqin Ltd. started collecting the data in the 1980s. The market slump has led to a 75 percent reduction in LBOs in 2009 and prompted investors to challenge a pay structure that rewards managers without requiring them to turn a profit.
“We would like lower fees, especially those not related to performance,” AlpInvest Chief Economist Peter Cornelius said in an interview at an industry conference last week in Geneva.
Investors would have been better-off last year owning shares of Pacific Investment Management Co.’s $156.9 billion Total Return Fund. The world’s biggest bond mutual fund gained 4.8 percent and levied a management charge of just 0.25 percent.
Time for ‘Diet’
LBOs plummeted to $37 billion in the first half of this year from a record $482 billion in the same period of 2007, data compiled by Bloomberg show. Stock market declines are forcing firms to write down the value of their investments, leaving investors with their first paper losses in at least five years.
Even before the LBO boom ended, firms earned almost twice as much from what they charged clients than from the gains they received from selling companies, according to a 2007 study by the Wharton School at the University of Pennsylvania.
LBO funds collect $10.35 of management compensation for every $100 they oversee, compared with the $5.41 they get from selling companies at a profit, according to the Wharton report.
“The whole budget of private-equity firms is going to change with no transaction fees, smaller management fees and smaller funds raised,” said Mounir Guen, chief executive officer of London-based MVision Private Equity Advisers Ltd., which helps buyout firms raise funds. “It will be like being on a diet and going to the gym regularly all of a sudden.”
First KKR Fund
When Henry Kravis, his cousin George R. Roberts and former partner Jerome Kohlberg raised their first LBO fund in 1978, they charged a $500,000 management fee equal to 2.5 percent of the assets they were seeking, according to marketing documents for the KKR Investment Fund.
The industry average stayed at about 2 percent until 2008, according to Preqin. Companies starting new funds this year are seeking an average management stipend of 1.8 percent. The figure is closer to 1.65 percent for offerings with more than $1 billion, Preqin reported.
LBO managers use the proceeds to cover their operating costs and typically take 20 percent of any investment profits they earn. The size of the average buyout pool increased 87 percent in the past five years to $1.5 billion, Preqin said.
“For years, investors completely disregarded lower management fees,” said Jon Moulton, founder of London-based private equity firm Alchemy Partners LLP, in a telephone interview. “It’s changing now.”
Four of every five investors in Europe and North America plan to request better terms over the next two years, according to a survey conducted in April by London-based Coller Capital Ltd., which buys stakes in LBO funds after they’re up and running.
Blackstone Offering
Investors are in a better position to dictate terms as capital for buyout funds becomes scarcer, said David Rubenstein, co-founder of Carlyle Group, the world’s second-biggest LBO firm by assets, during an interview last week in Geneva.
“It’s taking longer to raise any funds,” said Rubenstein, 59, whose Washington-based firm spent about 14 months to gather $1.04 billion for a pool to invest in Asia. “Some firms may have fees coming down.”
Blackstone Group LP, the largest LBO firm, plans to charge a management rate of 1.5 percent for a $15 billion fund that it’s halfway through putting together, said two people with knowledge of the matter, who declined to be identified before the fund closes. That would be equal to the fee on its previous pool, a $21.7 billion fund closed in 2007. Blackstone spokesman Peter Rose declined to comment.
HgCapital Cuts Fee
As HgCapital LLP started seeking 2 billion pounds ($3.3 billion) last year, it planned a 2 percent rate, said three people familiar with the decision, who declined to be named. HgCapital ended up reducing the figure to 1.75 percent as it struggled to reach the fundraising target and investors complained, the people said.
George Hudson, an outside spokesman for the London-based firm, declined to comment.
“It’s too early to say if it’s going to be a significant market phenomenon,” AlpInvest’s Cornelius said.
Amsterdam-based AlpInvest has about 40 billion euros ($56 billion) with firms, including Carlyle, New York-based Blackstone, as well as CVC Capital Partners Ltd. and Permira Advisers LLP, which are both based in London.
Investors cut commitments to new funds this year by 57 percent to $51 billion after the value of their stock and bond holdings tumbled amid the global freeze in the credit markets, Preqin said. Private equity executives are taking 18 months on average to compile new funds, compared with less than 12 months as recently as two years ago.
Relative Performance
“When returns are bad, people just stop giving funds money,” said Steven Kaplan, a professor at the University of Chicago Booth School of Business. “They’ll pay fees in the long run, but only to the good funds.”
The industry points to long-term performance to justify the compensation. In the five years ended Dec. 31, LBO funds generated annual returns of 25 percent, according to Preqin data. The Standard & Poor’s 500 Index fell 2.2 percent a year on average during the same period, including reinvested dividends, and the MSCI World Index was unchanged.
“There’s going to be much greater focus on justification of management fee levels,” said Joseph Dear, chief investment officer at Sacramento-based Calpers, in an interview last week at the Geneva conference.
Calpers has about 11.5 percent of its $184.6 billion under management in private equity funds. Returns from those investments with outside firms, including Blackstone and Carlyle, dropped to 5.8 percent in the 12 months ended June 2008 from 23.2 percent in the previous year.
Pension Payouts
The decline weighed on Calpers’s investment performance as the fund’s assets have dropped about 29 percent from a peak of $260 billion in 2007.
Calpers paid $376.3 million to private equity managers in 2007, up 50 percent from $249.9 million in the prior year, the pension plan said in its June 2008 annual report.
The pace of LBOs has slowed by about 75 percent this year, as the debt financing on which they rely for takeovers dried up with the credit crisis, according to Bloomberg data.
“Most of the large buyout funds haven’t been able to do deals because there’s no debt,” said Mark Cunningham, managing director at London-based Jefferies Helix Ltd., which helps raise funds for LBO firms. “Some of their limited partners have suggested that if the situation persists, they will want to revise down management fees.”
Calpers’s Dear said he expects firms to drop so-called transaction charges -- fees charged by the firms for buying and selling assets -- and raise smaller funds.
The California pension plan wants terms from buyout executives that “reflect a better alignment of their interests” with those of their investors, Dear said at last week’s industry conference in Geneva.