Investors are tired of paying for private equity jets

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A $ 2.7 billion private equity manager, named after the Monomoy Lighthouse in Nantucket Strait, has been forced to return nearly $ 2 million to its investors after U.S. regulators decided the ‘last year it failed to provide “full and fair disclosure” of the costs that were ultimately paid by customers.

Monomoy Capital is committed to helping clients navigate “rough waters,” but many similar examples of private equity managers exploiting opaque fees and expenses to increase their own profits make investors uncomfortable.

Investors say they are routinely billed for additional fees, such as renting private jets, on top of the standard “twos and 20s” – a 2% annual management fee and a 20% performance fee – charged. by the managers of equity groups, called general partners or GPs.

“Spending is the number one cause of misalignment between GPs and their clients,” said one investor managing a multi-billion dollar private equity portfolio.

Public criticism of private equity managers by institutional investors remains extremely rare. Most large investors are reluctant to speak out in case they damage their own reputation as trustees – keepers of their clients’ money – and because they fear being quietly excluded from joining new funds. raised by private equity managers.

But now rule changes could be underway.

The Institutional Limited Partners Association, a trade body, is urging U.S. regulators to require private equity managers to report all fees and expenses they charge investors in a clear and consistent format.

“I have made allocations to over 50 PE funds and there are a dozen where you don’t know what is being billed as an expense, even with the help of an external auditor that we hire to try and verify the expenses. information provided by our GPs, ”said the private equity investor.

Michael Frerichs, the Illinois state treasurer who oversees a $ 430 million private equity portfolio, in October called on the US Congress to adopt “new rules and sensible reforms” so that part The capitalist system’s “dangerously unregulated” does not cause further damage. institutional investors, businesses and workers.

Clear, standardized information on fees and expenses by private equity managers, who own or invest in 8,000 U.S. companies, “would lead to better decision-making” among investors, said Frerichs, a former Democratic member of the Illinois Senate.

Assets overseen by private equity managers have grown rapidly over the past decade to $ 4.5 billion, and contracts signed by investors allow GPs to levy additional fees for sourcing transactions, salaries of advisors and expenses for regulatory and compliance filings.

According to ILPA, a quarter of investors pay the administrative costs of private equity managers, such as in-house legal services, accounting and computer software.

Legal costs to create new private equity funds have more than doubled since 2011, a bill that is also being paid by investors who also have to shell out new expenses such as cybersecurity services for GPs.

KKR, the world’s second-largest private markets manager by assets, said it earned $ 480 million in capital market fees and an additional $ 152 million in “extra fees”, including monitoring and transaction fees in 2020.

“These fees include the services provided by KKR that its portfolio companies are encouraged to use. They accounted for 30 percent of KKR’s fee income last year, ”said Eamon Devlin, a private equity lawyer.

Ludovic Phalippou, professor of finance at Oxford Said Business School, said accumulated spending on investors at the discretion of GPs shows that the alignment of interests between private equity managers and their clients is “completely twisted. “.

“It’s amazing that it’s up to GPs to decide how much they get paid after signing the contract with the investor. This is effectively what happens when a general practitioner can choose what to charge as an expense, ”he said.

Investor demands to improve transparency standards led ILPA to create a new cost reporting model in 2016 for fees and expenses which the association says is “gaining ground”.

“All investors should have the necessary transparency to validate their fees and expenses with managers. Regulation can help achieve this goal, ”said Chris Hayes, General Counsel at ILPA.

But a significant minority of general practitioners remain reluctant to provide more information to their clients.

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According to Colmore, a specialist data provider, only 60% of U.S. private equity funds raised since 2017 have used the ILPA cost model or a similar reporting framework.

“Fee models based on the ILPA guidelines are now standard features of the services of fund administrators and software vendors. We are moving towards the point where ILPA type reporting standards will apply to all new PE funds, ”said Ben Cook, Managing Director of Colmore.

Gary Gensler, chairman of the Securities and Exchange Commission, said in October that he supported reforms to improve fee disclosure by private funds.

“Every pension fund investing in private funds would benefit from greater transparency and competition,” Gensler said.

His comments follow scathing criticism from the SEC last year which accused private equity managers of overburdening investors and covertly favoring their own interests and those of high-paying clients over other clients, in violation glaring of existing regulations.

Private equity managers are required to observe a fiduciary duty to act in the best interests of their clients. But most of the funds are domiciled in Delaware and the Cayman Islands, where local laws allow general practitioners to dilute or eliminate key elements of their fiduciary duties. Investors are paying for these contractual changes that weaken their own legal protections and strengthen the power of general practitioners.

Almost 48% of institutional investors reported changes or reductions in the fiduciary obligations specified in private equity funds when they made new allocations in the past 12 months, especially in North America and Asia regions -Pacific, according to ILPA.

“This goes to the heart of the issue of alignment between the GP and investors in a private equity fund,” said Chris Hayes, general counsel at ILPA.

The association is lobbying the SEC to tighten the rules so that the fiduciary standards that apply to GPs are not weaker than those covering other types of investment advisers, such as mutual fund managers.

Not everyone thinks PE needs to change the way it works.

“Transparency and accountability are important, but let’s not forget that investors understand that PE is an expensive asset class. . . investors have demonstrated that they are willing to pay these costs in return for the returns they are able to obtain, ”said Igor Rozenblit, founder of the Iron Road Partners consultancy for private market managers and former regulator of the SEC.

But Phalippou warns that regulators will need to tighten their oversight of GPs to ensure they “play by the rules” as opaque and complex private equity strategies take root deeper into the investing mainstream.

“For the moment, investing in PE is like walking in the jungle. All you can hope for is the lions will be friendly, ”he says.


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