CalSTRS’ private equity chief talks fees

Private equity fees in their various forms have long been a negotiating point for limited partners and fund managers, though in recent months there’s been heightened attention on the issue(s) and several high-profile limited partners’ approach to them, including the California State Teachers’ Retirement System (CalSTRS).

We recently visited CalSTRS’ head of private equity, Margot Wirth, to find out how one of private equity’s long-time and leading supporters is feeling about fees.

Have portfolio monitoring fees become more important given recent media attention?  

Wirth: Portfolio monitoring fees and transaction fees combined have historically been (probably) the third most important fee stream for the GPs, after carried interest and management fees. Some members of the general press discovered them three or four years ago and presented it as news that these fees exist and the “dumb LPs” have been oblivious to them, when in fact LPs have waged a long-term battle for at least 15 or 20 years and driven these fees down to such a point that for the next generation of buyout funds, the majority, have 100 percent offsets.

When I look at my chart of fee-offsets circa 2000, they were in the 50 percent range; that was the most typical. Circa 2005, most of those were going to 65-75 percent, and now, post global financial crisis, we’re at 80-100 percent. So the “real” story has been that these fees have been largely neutralized in most cases going forward. That’s important both because they’re so significant and also because they’re hard to track and less objectively specified.

The SEC has taken an interest in accelerated and evergreen portfolio monitoring fees; what’s your view?  

The accelerated monitoring fees and the evergreens were a black eye on the industry. I think those were wholly inappropriate when the GP benefited disproportionately.

Sometimes however, overall portfolio monitoring fee issue and this issue [of accelerated or evergreen fees] get conflated. The evergreen agreements were insidious because we didn’t expect them, we didn’t factor them into our models when we were trying to estimate overall fee loads. Once LPs realized what was happening, we started pushing back. The first thing that happened was that those evergreen agreements stopped being written onto new deals (or at least not being written when sharing ratios are not favorable or at least neutral for LPs). Then GPs started to either voluntarily forgo or greatly reduce the amount they would realize on legacy evergreens … and with this latest SEC action, now we’re recovering some of the past fees charged.

Have fees become more of a talking point generally?  

Yes, but first of all, let me state that this program has delivered a lot of value over the long-run to our beneficiaries. I would also like to state that our accounting and reporting systems meet or exceed industry standards and that all of our performance figures are net of all fees and carry.

Fees are always very important – fees and carry take a large portion of the gain so they’re terribly important. However, performance varies quite a bit in this industry and so it is ultimately net performance that determines the success or not of a private equity program. In other words, performance in this industry typically varies a lot more than fee loads. You’re a fool if you ignore fees but you’re also a fool if you focus on fees to the detriment of focusing on performance.

Performance and fee levels are often negatively correlated: the funds with the higher fees often have the higher performance (on a net, after fee and carry basis). This isn’t shocking to people who are in the industry, that it’s a market-based system that sets these fees, and better groups drive better economics (just like better baseball players get more lucrative contracts). Fees are important, but just as important can be fund size and other factors – waterfalls, GP commits, GP guarantees, clawbacks, and so on.

Just so I don’t get taken out of context, let me state for the record that obviously, all other things being equal, lower fee loads are always better. We seek lower fee loads, not higher fee loads. Ultimately though, we seek the best risk adjusted net returns.

We’ve heard of some GPs doing away with hurdle rates and clauses including key-man; is that something to be concerned about? 

I think those are the exceptions. Some groups do have more of an institutional strength, rather than being tied to an individual, and some of these funds may not have a key-man clause. Often though, those same funds might have a relatively low threshold for their no-fault divorce clause activation. Overall I’d rather take a low threshold on a no-fault, which gives you universal flexibility. But again, you can’t look at terms in isolation, you’ve got to look at the whole package.

An extended version of our interview with CalSTRS’ Wirth will be published in pfm’s January issue.