PERSPECTIVE FEES AND PERFORMANCE

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1 Fees and Performance 1 PERSPECTIVE TorreyCove Capital Partners FEES AND PERFORMANCE Management fees are always a hot topic with investors, no more so than in recent years, as performance has been under pressure and investors have more aggressively examined fee burdens. One has only to look to the development of the Institutional Limited Partners Association ( ILPA ) guidelines to see the lay of the land. So far, most of the focus has been on reducing the absolute level of management fees, guaranteeing a high level of attention to high fee structure alternative asset classes. Fee reduction is certainly a worthy goal, but we think that some important questions are not being given their due, including: Is there a significant relationship between management fees and performance? What is the real purpose of these fees? Are my private equity managers earning their fees through better performance? To provide insight into these questions, we reviewed some of the key literature in connection with management fees and investment performance. Unsurprisingly, the conclusions of these studies were mixed and the depth of the literature is not great. However, a general sense of the positions can be ascertained. On one end of the spectrum is a study by Martijn Cremers of the Yale School of Management that reaches two relevant conclusions: (1) private equity funds have not outperformed public indices in the ten years beginning in 2000 and (2) approximately 70% of all gross investment performance generated by private equity funds during the period were used to pay fees (including carried interest) to investment managers. These are pretty contentious conclusions, which have fostered some sharp disagreement amongst academic practitioners within the field. 1 Much further to the other end of the spectrum, in a study using private equity cash flow data from 1984 through 2010 (over 800 funds), Robinson and Sensoy come to a very different conclusion: there is essentially no relation between private equity fund performance (on a 1 Steven Kaplan of the University of Chicago has expressed considerable doubt as to the accuracy of Cremers findings, based on his own research, which indicates an approximate 20% return premium for the buyout asset class over private equity over public markets (with S&P 500 as the proxy). The crux of his argument rests on the presumed inferior quality of the Cremer dataset. Aleksandar Andonov, Rob M.M.J. Bauer, K. J. Martijn Cremers study commissioned by the Financial Times.

2 2 TorreyCove Capital Partners JANUARY 2013 net cash flow basis) and management compensation levels, and that more highly-compensated managers tend to earn back their fees, indicating no significant drop-off in net-of-fee performance. 2 In order to provide a comparison with these studies, TorreyCove reviewed the fee versus performance relationship for its client portfolios, going back to 1993 (with the vast majority of data more recent than 2000). 3 Our findings indicate that there is a slight negative correlation between management fee levels and performance. It might be most accurate to say that the worst-performing tercile had, on average, slightly higher fees than either the middle-performing or best-performing terciles. Most funds, however - including those with higher fees (see Figure 2) - performed well enough to cover the fee drag. s associated with the lower fee group and the middle fee group both averaged positive net performance and even within the high fee group, the majority of funds did not produce negative performance. To examine the issue in a slightly different light, we also computed the average performance of funds grouped into terciles based on overall management fee level. The results were consistent with our findings using the performance-based terciles: the higher fee group indicated somewhat lower average performance, the middling fee group fell between the low and high fee group, and the low fee group showed slightly higher performance than the other two (though the performance was positive in all three groups, once again indicating that, on average, all groups were able to cover management fees). 2 The study did find that the level of fees was more directly a result of cyclicality in the private equity fund market, as supply/demand dynamics allowed GPs to drive higher fees (and more weighting to fixed fees) during periods of high demand for private equity. Robinson, David T. and Sensoy, Berk A., Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance (March 14, 2012). AFA 2012 Chicago Meetings Paper; Charles A. Dice Center Working Paper No The basic method of the review was straightforward: funds were ranked into terciles based on the level of management fee and performance was calculated for each group. Only buyout funds were included, in order to eliminate the bias that would be injected relating to high-fee, poorperforming venture funds over the past 10 to 12 years (it should be noted, however, that even including venture funds, the direction of the fee/ performance relationship was consistent). Figure 1: Fee Versus Performance by Return Figure 2: Fee Versus Performance by Management Fee Low Mid Hi Low Mid Hi Return -8.64% % Fee <=1.5% 1.5<X<2.0% >=2.0% Mgmt. Fee 1.760% 1.723% 1.677% Ave. Return % % %

3 Fees and Performance 3 In order to shine some light on why there appears to be a modest inverse relationship between management fee level and average performance, we separated the data into three general groups based on investment style. Though not entirely consistent, the dynamic that emerged from this method pointed to an observable relationship between fund size, lower management fees, and average performance. One possible conclusion from this data is that larger funds, on average, tend to outperform smaller funds, while typically exhibiting somewhat lower management fee levels. This is not too surprising in relation to private equity, since only funds that perform well can typically raise successor funds, which in turn often have lower fees and higher AUM (scalability). One important aspect of private equity fee structure should be noted here: the overwhelming majority of private equity partnerships require the repayment of management fees to investors prior to the distribution of carried interest to the fund manager. This is a distinction from traditional fund (and most hedge fund) fee structures, and in effect means that most private equity funds only borrow management fees from their investors and must generate sufficient performance to cover the associated fee drag (plus preferred return) before calculating incentive fees. (Of course, for poorly performing funds, the fees are never repaid.) So the primary impact of fees (for funds that generate profits at least to the level of preferred interest) is the drag incurred due to the opportunity cost of the management fee, but it is not an irrecoverable cost in most cases, unlike traditional funds. Another notable difference arises from the nearly uniform application of offsets to the management fee from ancillary fees (transaction, financing, monitoring, etc.) that may be received directly from portfolio companies by private equity managers. These offsets are a staple of nearly all institutional private equity funds, and serve to defray a portion of the management fee burden borne directly by limited partners. Overall, TorreyCove s performance data, though more limited, is more generally in agreement with Sensoy and Kaplan and others that have reached similar conclusions. Figure 3: Data Characteristics Figure 4: Analysis Returns by Fee Average Fund Size by Fee Type Average Fee Average Return Average Size ($m) 20 VC & Growth 10 VC & Growth Venture Capital & Growth 2.12% 9.92% 517 Small & Middle 1.88% 9.79% 1,268 Returns Small & Middle Large Fund Size ($b) Small & Middle Large Large 1.45% 10.60% 6,002 0 Low Middle High 0 Low Middle High

4 4 TorreyCove Capital Partners JANUARY 2013 Of course there is a dearth of long-term, reliable, and conclusive hard data on the relationship between private equity fund performance and management fee levels. Our best sense from the available information is that there is not a strong relationship between the two, but that lower fee funds tend to come out looking somewhat more attractive on the margin. How Should a Private Equity Investor Approach the Fee Issue? In addressing the fee question for investors, a good place to start is with a discussion of how fees paid to private equity managers fit within the larger investment universe, what investors are obtaining for those fees, and how they can manage them most effectively. Why are Fees for Alternative Asset Classes so High? No doubt, private equity is an expensive asset class, along with most other alternative assets. A typical private equity fund will have an annual management fee ranging from 1% to 2% calculated on committed capital (not including carried interest). This puts it in the same league as hedge funds and certain real estate funds, and certainly well beyond nearly all fixed income vehicles and most public equity vehicles. Nevertheless, we think investors are better served by focusing less exclusively on overall management fee levels and more on the question of: What do the admittedly high fees paid for private equity investments buy? In this connection, one key thing to be cognizant of is that private equity is a highly laborintensive investment model. This becomes very clear when the comparison to traditional asset classes and even hedge funds is made. The ability of a private equity firm to scale its business is limited. Consider that fixed income titan PIMCO claims just under 700 investment professionals to manage assets of nearly $2 trillion, while a large established private equity investor such as KKR lists approximately 250 investment professionals to manage its activities, while its last two flagship private equity funds combined for less than $40 billion in total commitments. These figures are generally in line with what is observed in relation to other private equity firms, both large and small. While hedge fund management models show some variation, and some strategies tend to require more personnel to execute, the fact is that there are many multibillion dollar hedge funds that operate successfully with comparatively few investment professionals, often just a limited cadre of senior portfolio managers and a team of analysts (backed by risk-control professionals). The obvious reason for such ratios lies in the predominant strategy of most private equity investors to be closely involved with the management of their portfolio companies, both from a strategic and operational stance. There really is not any way to carry out such a strategy without adding human resources, which are by far the largest expense for private equity firms. Scale can only be achieved (and only to a degree) by making larger investments, and there is an upper limit to how far that strategy can be pursued (which was probably touched in the timeframe by mega funds). Given that the private equity investment model is high-fee, high-intensity, the next logical question has to be: Is this investment model justified? The evidence points in the

5 Fees and Performance 5 affirmative. A good illustration is provided via a comparison between private equity and more traditional asset classes (equities and bonds). See Figure 5. Traditional Versus Private Equity The available evidence suggests that private equity outperforms traditional asset classes over the long-term, with the important caveat that this generally applies only to funds performing in the top quartile. This assertion is supported by the notable benchmarks covering private equity, as well as some credible academic research. Further, the data indicates that for top quartile funds, the outperformance is sufficient to cover the additional management fees associated with private equity funds. Therefore, over time, the after-fee performance of top quartile private equity funds is superior to that of traditional asset classes such as equities. In and of itself, this would not be sufficient reason to tolerate the higher fees associated with private equity, because every asset class has top quartile performers that generate sufficient returns to make-up their fees over certain time periods. The additional element that makes the case for private equity is its persistence of return. Figure 5 Percentage % Source: Thompson Reuters Pooled Horizon Returns (All non-vc Global Private Equity); NCREIF Property Index; Bank of America Merrill Lynch US Corporate and Government A & Above Total Return Index; Russell 3000 Total Return Index; USD Total Return Money Market Index. All data as of 6/30/ Private Equity Private Equity Returns Real Estate Fixed Income Cash 5-year 10-year 15-year 20-year 10 A sizable body of research has been developed on the performance of traditional, publicly-traded equity funds over decades. The strong overall conclusion of this work is that traditional equity funds show very little to no persistence of return, meaning that the outperformance of a particular fund in one period of time has little to no predictive power in regards to outperformance in a later period. Put in even simpler terms, it is extremely difficult to pick a fund that is likely to outperform based on its past performance. This is in marked contrast to private equity. Though the volume of research is not nearly as large due to a variety of issues (difficulty obtaining data and more recent development of the asset class), sound studies point to a meaningful persistence of return observed for private equity funds, indicating that a top-performing fund is more likely to be followed by another outperforming fund. 4 Another point made by the academic research on traditional funds is that, for the vast majority of funds, the higher fees associated with certain funds rarely lead to outperformance on average and over time; therefore, higher fees associated with traditional funds are typically not justified. There are few exceptions to this, and, once again, the exceptions are very difficult to predict with any accuracy or timeliness. This is not too surprising, given the relatively efficient nature of the public markets, especially for the larger company sizes, which has the effect of forcing returns for most investors closer to the benchmark, and making it very difficult for traditional managers to establish and maintain a meaningful edge in terms of performance Year 10 Year 15 Year 20 Year Source: Thompson Reuters 5-, 10-, 15-, and 20-year Pooled Horizon Returns as of 6/30/12 for top quartile funds (All non-vc Global Private Equity). The reasonable conclusions to be drawn from research and experience then, are that traditional funds on average do not reward high fees and that there is little or no persistence of return. By contrast, the top quartile of private equity funds shows meaningful persistence and, in the 4 Steven N. Kaplan, Private Equity Performance: Returns, Persistence, and Capital Flows, The Journal of Finance 40 (August 2005):

6 6 TorreyCove Capital Partners JANUARY 2013 aggregate, does reward the higher fees paid by investors. Recommendations for Private Equity Fee Structure in an Institutional Portfolio Given what we know about private equity management fees, the following recommendations and considerations are suggested as part of a reasonable framework for assessing and negotiating private equity fees: Management fees should be seen as an income stream that allows a manager to provide for the stability and productivity of its investment platform, not as a profit center for the firm. The fee should be viewed in the context of the entire investment management firm, not only in connection with the fund - or even strategy - on which it is assessed. Further to this point, the management fee can only be assessed in the context of all other funds and revenue streams associated with the investment manager. Fee levels should be closely related to the costs of maintaining an appropriate investment infrastructure, which will vary from strategy to strategy (i.e., control buyouts with a heavy operational focus will require more infrastructure than a later-stage venture capital fund). By far the largest component of this infrastructure pertains to human resources, which are acquired in an open and highly competitive environment. While the compensation of private equity professionals may seem high in comparison to other professionals within the financial sector, it is most appropriately benchmarked to other alternative investment professionals (such as hedge funds). In effect, there really is not an absolute compensation level that is appropriate for most private equity professionals, but only a relative amount that derives from the dynamics of the marketplace for such professionals. Superior investment talent is a finite resource and a critical element of the private equity investment model, given the level of hands-on attention brought to bear on investments. Top-flight individuals have many options for lucrative careers, and for this reason, private equity firms will provide very attractive compensation packages to proven investment professionals. It is useful to examine the fee structures of larger versus smaller funds (both in terms of discrete funds and total assets under management). Typically, large funds have significantly lower management fees than small funds, on a percentage basis. In fact, we think this is the underlying reason for the small inverse correlation between fee levels and fund performance that we have observed. There are a variety of reasons that large funds can offer lower fees: more likely to have a positive and lengthy track record, much larger amount of assets under management in multiple funds, and significantly larger fund sizes on average. All of these factors enable large funds to give meaningful breaks on management fees to their largest and mostvalued investors, as well as charge a lower percentage management fee overall. However, this is a case where the percentage fee level does not tell the whole story, since larger funds are more

7 Fees and Performance 7 susceptible to the lure of fee gathering and are more prone to misalignment with investors, in relation to their smaller counterparts. The below table outlines two hypothetical fee structures. Clearly, the smaller fund, even though it has a higher fee, is more likely to exhibit better alignment with investors. The management team as a whole is drawing significantly less base annual compensation than their counterparts at the larger firms, and it is very unlikely that the senior management will get rich by producing mediocre performance and collecting fees, since they have fewer funds and strategies under management. In short, the management team of a smaller fund is usually more dependent on the outperformance of the investment platform and is therefore more closely-aligned with it (and by extension, the investors in its funds). 5, 6 Does Figure 6 indicate that large cap managers are predominantly fixed-fee-driven or that they are not sufficiently motivated by carried interest? No. After all, the incentive pay at larger funds is still highly substantial and investment professionals at such firms clearly find it highly attractive and motivating. What it does mean is that from a firm-wide perspective, the balance between compensation from management fees and from carried interest is more even than in the case of a much smaller firm. Thus, larger firms will have more tendency to view management fee income as an important element of their profitability, which can lead to asset-gathering behavior. Another element that should be taken into account relates to the ultimate performance of various size segments of the private equity universe in connection with average fee levels. As we have discussed elsewhere (in TorreyCove s recently distributed Buyout Funds: Large Versus Small. What to Expect Beyond Size.), there appears to be a relationship between fund size and average performance, at least for the top quartile of managers. In simple terms, large and mega 5 We would note here that this hypothetical is quite close to the real world information that TorreyCove maintains in its database. 6 A straightforward and simple analysis of this type is quite useful in framing the discussion on fees with an apples -to-apples metric that can be used across various funds and firms. It also focuses the analysis of fees where it belongs: on the relationship between a firm s investment capacity and expense structure. Figure 6: Large Versus Small Buyout Fees Large Buyout Small Buyout AUM of Two Most Recent Funds $25 B AUM of Two Most Recent Funds $400 M Average Fee 1.25% Average Fee 1.75% Investment Professionals 200 Investment Professionals 10 Fee per Professional $1,562,500 Fee per Professional $700,000 Total Management Fees $312,500,000 Total Management Fees $7,000,000

8 8 TorreyCove Capital Partners JANUARY 2013 buyout funds may be viewed as somewhat lower risk and lower return investments, while middle market funds tend to be more risky but offer higher potential returns. If this is the case, then the slightly higher fees paid to smaller funds may very well be worthwhile in terms of after-fee performance. The key matter to focus on, then, is not the absolute fee level, but the expected after-fee returns for different fund managers. For example, a credit-oriented or mezzanine strategy which promises more stable - but lower - returns would likely be over-priced at a fee level of 1.75% per annum, while a small cap buyout manager that promises higher returns might be fairly priced at 2% per annum. By implication, this means that the manager selection decision is substantially more material to fund performance than the level of management fees ultimately agreed-upon. The essential point here is that it is worth paying more to a high quality manager that has an ongoing and substantial influence on the value of its portfolio than opting for a manager with a lower fee that will not provide similar added value or that operates a lower-risk, lower-return strategy. Conclusion The post-crisis years have seen a vigorous focus on management fees by major institutional investors, and rightfully so. During the boom years the leverage on this matter was on the side of the investment managers and so some balancing is in order. All things equal, the minimization of management fees is a very worthy goal. The problem arises with the equal part. Private equity differs from traditional asset classes in important ways, namely in its dependence on top investment talent to generate the outperformance it promises, its intensive and active investment strategy, and the relatively wide dispersion of returns between the best and worst managers. For these reasons, management fees are of secondary importance in the decision on whether to invest with a particular private equity manager. Being tough on fees is prudent, but there is a line that should not be crossed. The private equity manager that offers well below market fees is usually not one that should be backed, as it will generally be unable to attract and retain talented investment professionals and is much more likely to encounter major organizational instability. The best way for an investor to view the issue of management fees (or fixed fees in general) is as a necessary cost of maintaining the investment infrastructure and capability of a superior private equity manager. Myopia regarding the quoted percentage fee and an approach that only takes this into account will divert focus from other critical issues regarding alignment and investment firm stability. An approach that assesses the reasonableness of the management fee in the context of an investment firm s strategy, assets under management, organizational size and structure, alignment, and incentives is much more likely to produce superior decisions. This TorreyCove Perspective has been prepared by TorreyCove Capital Partners LLC for informational purposes only. It does not constitute legal, securities, tax or investment advice or an opinion regarding whether investment is appropriate. Readers should not act upon this information without first seeking advice from professional advisers. TorreyCove Capital Partners is a global alternative investments specialist, currently overseeing over $20 billion of private equity assets. As a client-oriented firm, we create value through a combination of private equity market intelligence, objective advice, insightful investment guidance and selection, and innovative investment products. To find out more about our firm, please visit: