Heat being raised on public, private accounts
Active money managers that pride themselves on adding value to portfolios increasingly are under fire to justify the fees they charge, and some have realized a refusal to budge will see them increasingly bypassed by investors.
“The value proposition of asset managers is being questioned,” said Luba Nikulina, London-based global head of manager research at Towers Watson & Co. “There are areas where many investors believe there is a possibility that, if you apply a sufficient level of skill, you can create alpha. The question is, how much of that alpha goes to the asset owners, and how much to the asset manager? Fees basically can wipe out the whole value proposition.”
Money managers covering both private and public markets said they are experiencing increased pressure from investment consultants to alter their fee structures: be it through the introduction of fee clawbacks, the scrapping of charges on committed capital, or fee reductions.
“Yes, we do see pressure from consultants — fees will always be squeezed, but equally there is a line to say, "you get what you pay for,'” said Euan MacLaren, London-based head of U.K. and Ireland institutional business at Natixis Global Asset Management. He stressed the importance of true active management, as opposed to closet indexing. Mr. MacLaren added NGAM has not altered the way it charges fees.
A recent white paper by management consultant Casey, Quirk & Associates LLC, “New Arrows for the Quiver: Product Development for a New Active and Beta World,” concluded investors worldwide will invest almost $4 trillion into “new active” strategies, and more than $1 trillion into passive and smart beta allocations, over the next five years. The consultant defines “new active” as asset classes including multiasset, unconstrained equities and real assets and other private strategies.
That will be funded in part by at least $2 trillion of redemptions from index-benchmarked active strategies. The changes will force money managers to change the way they operate and Casey Quirk said in its study that recruitment will be affected, with an anticipated uptick in talent liftouts and mergers and acquisitions to gain the necessary capabilities to remain competitive.
“There's a lot of focus on value-add — the industry is oversupplied with vendors, and increasingly you'll have dozens of similar-looking fund managers offering similar-looking products fighting over ever-slimmer organic growth in the industry,” said Ben Phillips, New York-based partner at Casey Quirk. “Investors still want active management — benchmark-agnostic, outcome-oriented active that truly isn't correlated to market gyrations. So winning the war against passive involves some value-added strategies and creative use of pricing, but the best weapon remains being a better active investor.”
Private markets trend
However, the trend is increasingly evident in the private markets industry, with charges on non-invested capital in private equity arrangements, a particular bugaboo. Most of the management fee is charged on committed capital in private equity, said sources.
“That is why this big trend for co-investment among large asset owners has appeared,” said Ms. Nikulina. Investors are working around the fee drag on non-invested capital, avoiding the J-curve effect this has on returns.
“The vast majority of private equity firms are still charging fees on committed capital during the investment period,” said Richard Moon, investment director at RPMI Railpen, London. “There has been some movement to fees charged on invested capital on a number of fund-of-funds products, where the business model is under greater pressure. Also there have been some fees on invested capital structures for newer or niche strategies where a private equity firm is proving a concept or needs to raise capital quickly.” RPMI Railpen runs assets for the £21 billion ($32.6 billion) Railways Pension Fund, London, which has about 10% of assets allocated to private equity.
Mr. Moon added the investment manager is seeing little movement in fees from the top-tier private equity managers, “who are oversubscribed even at current fee levels.”
The current market environment is conducive to fundraising, but not to investing and sourcing deals. “So the J-curve for recent vintages will be very deep, which is not very good for investors, particularly if they are paying fees on non-invested capital,” added Ms. Nikulina.
Fuel has been added to the argument by a decision by private equity firm Terra Firma Capital Partners Ltd. in February to alter its offering, aligning its interests with those of investors following conversations with 50 of its largest investors. Terra Firma decided not to charge fees on committed capital, to invest at least 10% of its own manager money into any fund or deal, and to ensure it can add alpha via its strategies.
“The majority (of investors questioned) said they were reducing the number of relationships that they had, and for beta (performance) would concentrate on the larger firms,” said Guy Hands, chairman and chief investment officer at the London-based firm. The midsize private equity market —firms that have less than $10 billion of assets and fund sizes of less than $3 billion — “is very, very competitive,” and Terra Firma needed to distinguish itself, he said.
The main objection on fees was that investors could not see why a firm that had been in business for 10 or 20 years and had “presumably made a lot of money out of private equity” was still charging high fees.
Competitor reaction has been mixed. Some would prefer to know that they are making money right now by charging fees on committed capital rather than waiting to see if a deal works out.
“The majority of firms, however, understand,” the need for changes, said Mr. Hands.
Direct transaction volume by sovereign wealth funds, for example, including allocations to real estate, infrastructure, private and public security purchases, was $63.2 billion for the year through July 2, according to data from the Sovereign Wealth Fund Institute. In 2014 it was $120.1 billion, increasing almost 700% vs. 2006 figures.
“As an industry, if we don't respond to our investors' requirements, there is a risk that we get disintermediated, and find that the private equity deals done by sovereign wealth funds and pension funds directly increases,” said Mr. Hands.
Meanwhile, a London-based spokesman for global private equity fund investor Pantheon Ventures (UK) LLP said the firm has introduced increased flexibility over the past few years in the fee structures it offers clients. “The traditional model of fees on committed capital doesn't seem to work for everyone so there is a movement towards fees on invested capital,” he said in an e-mail. “It definitely varies between clients.”
These moves are unusual, said sources. A reduction in fees, or change in the fee structure “is not something we are seeing across the board,” said Alex Koriath, London-based head of Cambridge Associates LLC's U.K. pension practice.
RPMI is seeing some movement around the margins. “Generally concessions are being made by offering no fee/no carry co-investment,” which Mr. Moon said is usually to fund investors paying full fees — “or reductions for investors committing to the first close rather than moving to fees on invested (capital only.) Clearly, we prefer fees to be on invested capital only but we look at each situation on a case-by-case basis to ensure that the total fee level is suitable, and the fee structure promotes good alignment with the manager,” said Mr. Moon.
“We are seeing more downward pressure on fees in the private markets space, but it varies across strategies,” said Sanjay Mistry, London-based director of private debt and private equity fund of funds at Mercer Investment Consulting. “Most of the funds that are seeking to raise capital in closed-end structures tend to operate with a fee on committed capital, but there are examples of moves to fees only on invested capital.”
This article originally appeared in the July 27, 2015 print issue as, "More managers feel pressure to adjust fees".