Alternative fee models: not the norm

With the promise of outsized returns comes the expectation of outsized compensation.

The pressure from investors on private equity and other alternatives managers to reduce their fees is not going away. Presupposing that investors are of the view that the promise of higher returns offered by private equity and other alternatives merits the higher fees relative to other asset classes, they nevertheless want to feel like they are getting value for money. On this front, findings by the Oxford Saïd Business School around recent fee hauls in private equity and performance relative to public markets does not read wholly favourably. Furthermore, as investors are themselves subjected by their stakeholders to greater scrutiny as to the fee drain they are suffering, they in turn scrutinise their alternatives managers. In this light, this article considers some of the arrangements being implemented to reduce the overall fee burden and discusses some of the pitfalls to bear in mind.

The typical private fund model in private equity and similar alternatives is a management fee and carried interest arrangement, often with discounts and incentives offered to investors based on timing and/or size of commitment. However, many investors are looking for a more tailored approach, with a structure to suit their needs and, importantly, a fee model that veers from the norm.

Co-investment is often used as a means to offer low or no fee deployment of capital to investors. Furthermore, based on anticipated co-investment opportunities, managers will sometimes sell the overall fee package based on the blended fee outcome across both the fund and expected co-investment. Whilst appealing, investors need to be comfortable that they have the internal infrastructure and expertise to do due diligence and approve co-investment opportunities as they arise. Managers can also find themselves juggling the need to deliver the quantum of co-investment pitched to their investors while ensuring that that it is primarily the fund’s interests they have in mind when originating investments.

Another way to re-visit the fee basis is through managed account arrangements. Fees for investing in a managed account are likely to be the same as those that an investor would have obtained if they had gone into the related fund with the same commitment. But increasingly, multi-strategy managers are agreeing to managed accounts that give investors exposure to a range of underlying strategies through one and the same account. A blended fee basis can then be agreed on across the whole arrangement. As well as being a more holistic solution to an investor’s alternatives allocation, this also helps reduce the overall fee leakage relative to separate allocations to each relevant fund. This said, a manager needs to think carefully as to how this impacts any most favoured nation provision it has granted to other investors.

For some, a more deal-by-deal arrangement can help mitigate fee drain. This normally reduces fees on undrawn commitments, as an investor would typically only pay a fee based on invested capital. However, it can result in any carried interest effectively being deal-by-deal, which can work against investors.

Equally, there are plenty of more creative fee solutions that managers might consider within their funds. A lower management fee in exchange for a higher carry is one. Fee discounts based on investor loyalty over fund vintages is another (say, buy four, get the fifth free!). Finally, some managers have launched longer-dated funds for those investors interested in gaining longer-term exposure to private equity assets, which naturally come with reduced fees compared to their more traditional brethren. But there remains a general longer-term trend amongst all but the most successful managers towards lower headline fees.

There is clear evidence of investors focusing more on fee calculations, with bigger investors starting to have external advisers help them assess this. But nothing takes away from the fact that unless an investor has the expertise to bring the management of its alternatives allocation in-house, it will have to pay someone to do it. And with the promise of outsized returns comes the expectation of outsized compensation.

Alex Amos is an investment management partner at London law firm Macfarlanes. Alex advises a wide range of asset managers and investors on the structuring and establishment of, and investment in, alternative funds. His particular focus is on credit and real estate funds.