PE investors should swap new cash for lower fees
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
NEW YORK — The buyout industry should slowly emerge from its fundraising drought in 2011. After having more capital returned to them in 2010, investors will be more inclined to put money into private equity. But it’s still a buyer’s market, and the time is ripe for investors to push hard to overhaul the fees they pay.
It has been a brutal two years for LBO firms seeking fresh funds. It took the last seven quarters to match the $365 billion the global industry raised in the first six months of 2008, according to research firm Preqin. There could be fresh momentum after an uptick in successful exits in 2010 and with big initial public offerings of HCA, Nielsen and Toys R Us among those teed up. But it still won’t be easy for private equity firms to raise new capital.
Blackstone provides a cautionary tale. The blue-chip buyout shop expects to close its sixth fund with nearly $15 billion. It’s an impressive sum — but still only about two-thirds of its last effort. Meanwhile, BC Partners, the European firm, after selling several portfolio companies onto public markets this year, is ambitiously gunning for 6 billion euros, a little more than the fund it closed in 2005. Rivals that lack the brand equity and investment record of such industry giants will struggle to get anywhere near what they have raised before.
Even the best of breed, however, could find themselves over a barrel if investors find the will to use their negotiation leverage. Again, Blackstone provides some insight, at least on a small scale. The firm agreed to share 65 percent of any deal-related fees with its limited partners, up from 50 percent. That’s nice, but there’s more chiseling to be done.
First, investors should pound away at management fees. Most firms take out 1.5 percent, even on funds that aren’t yet invested. The coming year presents an opportunity to pare back these fees, providing an extra incentive for private equity firms to find appropriate investments.
Second, the distribution of carried interests should be revisited. As it stands, buyout bosses immediately start receiving their 20 percent cut of increased valuations. For instance, take the example of a $1 billion fund with 10 investments of $100 million. If the first portfolio company sells for $200 million, $180 million is returned to investors. But the firm’s managers also extract $20 million — even though investors have yet to be made whole on their full commitments.
With many buyout firms fighting for survival and others hard-up for fresh funds, there’s an opportunity for investors to reform the private equity model in their favor. They shouldn’t squander it.