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February 19, 2009

Is the PE fee structure set for decline?

In the PE industry, a 2% management fee and a 20% "carry" (the so called and "2 and 20" or 2/20) seemed set in stone. . Until 2008. According to a new survey by Mercer, fees are expected to decline in 2009 - especially for the fund-of-funds segment.
The survey shows alternative investment strategies to have the highest fees for each dollar of investor capital allocated. According to Divyesh Hindocha, worldwide partner in Mercer’s investment consulting business: “One needs to take care before passing judgement on this evidence, as return and risk considerations should take priority over fees. It is fair to conclude, however, that fund of fund approaches extract a heavy premium from the alpha generation process and we would expect this to be under challenge in the new financial environment.”

Mr Hindocha commented, “Historically, fees are higher in those strategies where asset managers have the most potential to outperform. However, anecdotal evidence suggests that increasingly asset managers will have to negotiate their fee structures with ever more cost-conscious clients. “Alpha is now competing with cheap and plentiful beta and capacity is no longer an issue for most strategies,” he continued. “There is the recognition that institutional investors are no longer willing to pay upfront, such large proportions of the potential alpha, especially for the more complex strategies.”

KKR's move earlier this month to charge LPs in its new infrastructure fund a 1% management fee and 10% carry, seems to reinforce the survey results. Extracts from the PEI report on the KKR announcement:
The size and appropriate timing of fees has been a hot topic of debate in recent years among private equity firms entering the infrastructure asset class. Many GPs have sought to apply the traditional 2-and-20 model into the asset class, but given the steadier, lower returns many LPs expect from the asset class, that pricing model has come into question.

...In light of current market turmoil, many private equity firms have also been cutting their fees. Last month, mega-buyout firm TPG sent a letter to its LPs saying that it would allow them to reduce their commitments by as much as 10 percent and cut its annual management fees by one-tenth, regardless of whether the LPs cut commitments.

Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports. Email the author at arun@ventureintelligence.in