The controversial issue of whether defined contribution (DC) pensions schemes should embrace the 2 and 20 performance fee structures common in the world of private equity was a key area of debate at an industry round table last month.
VIEW A PDF OF THE ROUND TABLE SUPPLEMENT HERE
Government proposals that allow performance fees on private equity holdings within defined contribution pensions have been met with criticism in some quarters. But several delegates at the event were generally supportive the concept of performance fees, with Capital Cranfield professional trustee Andrew Cheseldine arguing that a hurdle rate of 8 per cent meant 2 and 20 private equity investments would normally beat most other asset classes in the default before any performance fee was actually paid.
Charge controversy
The event was hosted by Natixis Investment Managers, which presented potential performance outcomes for portfolios with differing levels of private equity holdings for typical asset allocation approaches based on figures from Corporate Adviser’s CAPA-data analysis of over 23 master trust and group personal pension (GPP) default funds.
Cheseldine’s comments contrasted those of his Capital Cranfield colleague Andrew Warwick-Thompson, who was also former executive director for regulation at The Pensions Regulator, who has in recent weeks been critical of the Department for Work and Pensions for allowing performance fees to be excluded from the charge cap, citing intergenerational unfairness.
Nest, the giant public service provider established by the UK government, has resisted two and 20 charges in its pitch for private equity, that will see it placing around £1.5bn with Schroders Capital by 2025, as it targets a 5 per cent allocation.
Eric Deram, managing partner of Flexstone Partners (pictured), a private investment firm owned by Natixis, said that a 2 per cent management fee plus a 20 per cent carried interest over a hurdle rate of 8 per cent was the industry standard, and would have to be paid if DC schemes were serious about getting access to decent PE managers.
Hard bargain
So how do proponents of performance fees for private equity respond to the challenge from the UK DC sector that providers can drive a hard bargain because they will have a steady and growing flow of assets that will eventually match those of the Australian DC market?
Deram pointed out that the Hostplus Superannuation Fund, which surpassed AUS$100bn of assets earlier this year, has a 20 per cent allocation to private equity specifically, with 40 per cent in illiquids, and it pays fees on a two and 20 basis.
Deram said: “The very successful VC funds that you may have heard of, they have zero hurdle and 30 per cent carried interest, and they are 50 times over allocated every time they raise a fund. So they will never change their terms. But they deliver performance that is mind blowing. They have triple digit IRR, but the only people who get to invest in them are the likes of the Yale, Harvard and Princeton endowments.”
Cash waterfall
Deram outlined the carried interest waterfall mechanism that operates in private equity to manage distributions between general partners (GPs), who are the managers of the fund and limited partners (LPs), the investors.
Once the investment is made there are typically no payouts in the first two years. Stage one of the waterfall sees the LPs’ initial capital returned to them before any profit share is paid. Stage two sees the LPs receive their ‘preferred return’ or ‘hurdle rate’ up to the threshold agreed.
Stage three in some arrangements is the catch-up provision, which kicks in once and only if the hurdle rate has been met. This allows GPs to take profits so their overall return matches that of the LPs, under the agreed ratio. For example, on a two and 20 arrangement, they will receive a quarter of what the LPs have received under stage two.
The final stage is when the profit-sharing mechanism takes effect and 20 per cent carried interest is paid to the GP.
Deram said under typical European waterfall structures, one needs to reimburse 100 per cent of the capital on the entire fund basis, whereas the US waterfall model is deal by deal, with an escrow account to make sure that the GP doesn’t get too much performance fee if later investments underperform compared to earlier investments in the fund.
Private matter
Cheseldine said: “There is a wide range of assets here. Smart has productive finance bond elements which don’t pay anything like these fees. But this is different because we are looking at equities and performance.
“My only concern is for outperformance for the member in the long term. I’m relatively relaxed about paying higher fees as long as it’s within the charge cap, within the regulations, which are now broader.
“But I want to make sure that it works. And I also need to make sure that there’s cross-generational fairness. I don’t want to have someone who gets the benefit from this and then doesn’t pay any of the fees. But I think the way that Eric’s described the waterfall and certainly with escrow accounts, that would work.”
Lawrence said: “It is insane to exclude 80 per cent of the market effectively. The 20 per cent that is left is probably not going to be the top 20 per cent.
Deram pointed out that for eight years out of the most recent 20-year period for which figures are available the median internal rate of return did not exceed the 8 per cent trigger for which carried interest is paid.
“This gives you a sense of the impact of the hurdle rate,” he said. “Alignment of interest is the famous principal versus agent problem. I would say it is equivalent to stock options for managers in a publicly traded company.
He also highlighted the fact that the hurdle rate was introduced at 8 per cent when that was the risk-free rate.
Hedge contrast
Deram also stressed the difference between hedge fund and liquid funds with performance fees, which paid managers on high water marks in a good year for the fund, even though they may never regain that high valuation again. While hedge funds paid performance fees on paper profits, often over short time periods, private equity 2 and 20 structures only paid out on actual profits, and typically saw no carried interest payouts until after seven or eight years.
Deram said funds are typically 10 years in length although in practice go on to 12 years. “For the first few years that you invest you have negative cashflows, and then as you start resetting your portfolio you generate distribution. Remember the 20 per cent carried interest is very rarely paid to investors before year eight or nine.”
He cited figures from research carried out by data firm Prequin which found that 68 per cent of private capital fund investors believe their interests are aligned with those of the ‘general partners’ managing the investments.
For Cheseldine, who sits on the boards of the Smart and Lewis master trusts as well as Aon’s GPP investment committee, perception is as much a challenge as the actual charges.
Cheseldine said: “The biggest challenge here is perceived fairness bias, because to a user, a trustee or a member, saying you’re taking 20 per cent of the outperformance sounds enormous. But if you recast that with a hurdle of 8 per cent, it is less of an issue because realistically I don’t think many members expect more than 8 per cent in today’s environment.”
Asked whether, as a trustee, he would be comfortable with such a charge structure, Cheseldine said: “As an individual I might be comfortable. But I would need to figure out how we would get that across.”
Communication challenge
James Lawrence, of Smart Pension, said his organisation had figured out a better way to phrase the charges.
“The discrepancy between the best and worst funds is huge, and you need to be in those very best funds. They are oversubscribed consistently. So why would they negotiate?” said Deram.
Cheseldine said: “The biggest number for me is that hurdle rate of 8 per cent Because for the other asset classes that you’re investing in, how confident are you that any of them are going to get close to that? If you think 8 per cent is a good, relatively high return, why would you be particularly worried about paying extra charges for going above 8 per cent?”