Funds wake up to high fees

If you have been holding private equity (PE) funds over the last cycle it will come as no surprise to be told that the industry is generally better at "enriching its own managers than producing investment profits". That, at least, is the conclusion from an investigation into PE returns by the Financial Times. The good news is that those who invested in PE from 2001 to 2010 did make a positive return (4.5%), something that you could say makes the average PE manager superior to the average traditional fund manager.

The bad news, however, is that returns should have been a whole lot higher. Add up all the money US pension funds have paid to their managers over the last decade and, according to Yale's Professor Martijn Cremers, "about 70% of gross investment performance" has gone in fees.

So what are these fees? Much the same as those in the hedge fund industry. The punter pays 2% of the value of their assets every year as a management fee, and then 20% of the value of any returns on their assets. But there's an extra sting in the tail for PE investors: all hedge fund and PE investors pay these fees regardless of whether the money is actually invested or not, but while money you commit to a hedge fund is usually fully invested immediately, the money you put in a PE fund is not.

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Invest in a hedge fund and you get what you pay for in the sense that someone in Mayfair will randomly shift your money around the market to save you the effort of losing it yourself. But invest in a PE fund and your money mostly sits around in cash while its managers wait for brilliant ideas to come along.

So, as the FT explains, if a $1bn fund invests only $100m in its first year, the fee will still be $20m 2% of the $1bn but 20% of the invested capital ($100m). The industry puts up the usual defence (that because everyone does it, it's ok). The PE Growth Capital Council told the FT that two and 20 is "industry standard". I think we all know what we think about that.

On the plus side, I think fund managers in Britain are beginning to get it. Increasingly when they turn up to tell me about new launches of one kind or another, they start by telling me either about how low their fees are, or how low their fees will become when their fund is just a little bigger.

This week, I was pleased to see that even L&G Investments is going with the flow on fees. From the end of this month, it will cut the up-front fee (the one it likes to call a "service charge") from 3% of the value of the assets you invest to zero, as long as you invest directly (not via an independent financial adviser, who needs a cut).

I dare say that, like most of the firms offering seemingly low fees, they'll find a way to claw back the lost revenue elsewhere. But the ongoing marketing focus on fees does tell us one thing about the fund management industry: they know total fees are too high. And they know that we know.