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We use within-fund variation in net-of-fee returns to assess the degree to which fees vary across investors in the same fund. To do so, we rely on a subset of Preqin’s database of LP fund-level cash flows that covers $516bn of investments made by 231 US pension funds into 2,535 private market funds. Our analysis yields three main findings...
Emil SiriwardaneProfessorHarvard University
Over the past 20 years, state and local defined-benefit pensions have increasingly shifted capital out of traditional asset classes like fixed income and into private market investment vehicles like private equity and venture capital. While investment costs in private markets are generally known to be large, there is very little systematic evidence on how they are determined, mainly because contracts between LPs and GPs are privately negotiated and rarely observed. These issues are further compounded by the complexity of limited partnership agreements (LPAs) and their associated side-letters, which can make it difficult for LPs to accurately predict costs when investing in a private market fund.
In this study, we attempt to shed light on the costs that LPs face when investing in private markets. The ideal approach to this problem would be to directly analyze a large sample of fee contracts between LPs and GPs, yet this type of data is not easily accessible to researchers. Nonetheless, we overcome the inherent data opacity issues in this setting by comparing the net-of-fee cash flows of multiple LPs invested in the same private market fund. In other words, we use within-fund variation in net-of-fee returns to assess the degree to which fees vary across investors in the same fund. To do so, we rely on a subset of Preqin’s database of LP fund-level cash flows that covers $516bn of investments made by 231 US pension funds into 2,535 private market funds. Our analysis yields three main findings.
First, there is sizable within-fund variation in net-of-fee returns. This variation appears unlikely to be driven by bespoke investment structures like co-investment, differences in accounting across LPs, or measurement error in reporting. Instead, our evidence suggests fees are the primary reason why LPs invested in the same fund can nonetheless earn different returns. As one way to measure the size of these within-fund return differences, we compute how much better off each LP would have been had it earned the best observed return in a given fund. According to this metric, the LPs in our sample would have earned $8.50 per $100 invested had each received the best ex-post fee contract in its respective funds. This estimate can be naturally interpreted as capital that was redistributed to GPs or other unobserved investors. We also consider several alternative ways to measure within-fund fee dispersion, all of which suggest economically meaningful differences in fees across LPs in the same fund.
Second, it is common for funds to have tiers of investors in terms of fees. That is, LPs in the same fund tend to be bunched together in terms of their net-of-fee returns, with a typical fund having 2-3 tiers of investors. We then provide estimates of how management fees and carry rates differ across investor tiers. Intuitively, this is possible because differences in management fees are sensitive to a fund’s age and differences in carry are sensitive to a fund’s profitability. Across investor tiers in a given fund, we find that management fees can differ by 56-86 basis points and carry rates by 6-18 percentage points, though the exact differences are likely to depend heavily on GPs.
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Our last key finding is that an LP that is a top-tier investor in one fund is more likely to be top-tier in its other funds, at least in terms of fees. The identity of top-tier LPs is partially correlated with an LP’s size and its relationship with a GP. This result makes sense, as GPs may offer fee discounts to larger LPs that lower fundraising costs or will credibly commit capital to future funds. Nonetheless, these and other observable characteristics (e.g., check size) have surprisingly low explanatory power for why some LPs consistently pay lower fees than others when investing in private markets. Put differently, two LPs that in principle should have similar bargaining power, information, and risk preferences still appear to systematically pay different fees when investing in the same fund.
In summary, our analysis suggests that differences in fees can have a sizable impact on returns for investors in the same fund. In some cases, return variation within a fund can be as large as variation across funds. Put differently, for some LPs, fees can have as large of an impact on returns as manager selection. We view this study as an important step forward in terms of understanding the costs that LPs face when investing in private markets, and we are actively exploring these issues in follow-up research using Preqin’s data.
The full paper is available online here.