This article is sponsored by Gen II Fund Services.
Internal expense ratios at private equity firms show surprisingly wide variability. That’s why benchmarking expense categories provides useful information about peers’ average spend on back- and middle-office capabilities, information that can raise important strategic questions as management companies increasingly face heightened scrutiny to drive efficiencies and comply with new regulations, all while scaling their business. Gen II’s survey of management companies’ core expenses categories, which captures expense percentages across a range of firm sizes, provides a fresh view into how firms prioritize their spending.
While no two private equity firms are exactly alike, they all share a set of common costs to operate their business, including compensation, technology and professional fees. Given the range of expenses among the various firm categories, it’s clear why management companies are under the microscope. It’s important for a firm to understand where they sit on the trend line to make the case either for increased investment in certain areas or to get a sense of where they may be overspending and committing precious resources that could be better served in other areas.
To be sure, many private equity managers tend to view anything outside of sourcing new deals, driving portfolio company growth, and realizing investments as a distraction to their day-to-day priorities. But against an increasingly competitive backdrop to raise new funds, limited partners are indeed scrutinizing back-office capabilities. And ILPA’s updated version of its standard DDQ delves into everything from management company economics to cybersecurity, compliance protocols and whether or not firms utilize an independent fund administrator.
Returns still matter, but all else being equal, the extent to which firms invest in their management company operations can make the difference between securing a commitment or walking away empty-handed.
“The scope of management company challenges continues to grow more complex, particularly around regulation”
The good news, according to EY’s latest Global Private Equity Survey, is that a majority of private equity firms believe their management company was ahead of its peers in terms of “institutional maturity” (including 84 percent for the largest fund managers versus 56 percent among respondents at smaller firms). As might be expected, a minority of managers believe their management company could be considered best in class (19 percent for the largest fund managers, 14 percent of respondents at midsize and just 11 percent for smaller firms.) The same survey seemed to indicate that midsize firms see the correlation between AUM and back- and middle-office capabilities, as 39 percent of fund managers with between $2.5 billion and $15 billion of total assets under management cited enhancements in these areas a top strategic priority.
New pressures mount
The scope of management company challenges continues to grow more complex, particularly around regulation. As private equity grows in scale, the SEC has ramped up its scrutiny of management companies. Earlier this year, the commission unveiled a wide-ranging proposal to overhaul private fund reporting requirements. Making sure management company books and records are in order and easily reportable and auditable has become a higher priority.
Moreover, there’s been a rapid increase in the number of GP stake sales, in which private equity firms sell minority positions in their management companies to third-party investors. This trend is helping to institutionalize the back and middle office, and some investors in this area, such as Goldman Sachs-affiliated Petershill Partners, even differentiate themselves through GP services to aid in everything from human capital and ESG engagement to operations consulting. The presence of a third-party owner can complicate audits, compelling the management company to provide a more robust set of reports to meet the requirements of their new minority owner. And that has put a lot of stress on management company teams who have not reported on those metrics before and are now forced to on a going-forward basis.
Looking ahead, human capital and the value of retention has become a key priority as private equity firms increasingly recognize the costs of losing talent. This is no small consideration for the back-office roles at management companies, given the nuances and evolution of reporting requirements and the constantly moving target of new regulations. Highly experienced talent is more valuable than ever, as there’s no question that private equity fund structures become more complex with each passing year.
A wide divergence in expense allocations
Gen II’s management company data captures expense percentages for six categories (compensation, professional fees, occupancy, technology, travel and entertainment, and other) across three size categories based on AUM. The high and low datapoints often reveal a wide divergence in expense allocations, underscoring that there is no set template for firm management spending.
Compensation naturally dominates expenses across the three AUM groups. The blended average for the compensation percentage moved up to 69 percent, from 66 percent when Gen II last surveyed management companies in 2016. The smaller firms (AUM between $50 million and $500 million) had the lowest compensation percentage at 63 percent of costs, reflecting the larger impact of overhead. Compensation at both midsize ($500 million to $1 billion AUM) and large ($1 billion-plus AUM) firms averaged 72 percent. In the $1 billion-plus category, average compensation as a percentage of costs grew by 7.5 percent over the five-year period. In terms of outliers, compensation percentages were as high as 96 percent of total costs and as low as 26 percent in the smallest AUM category, but also as high as 87 percent and as low as 44 percent in the $1 billion-plus group.
Legal, accounting, consulting and other services are perhaps the most fungible expense item from year to year, particularly when looking across the different AUM levels. For instance, in the smallest category, firms with assets of between $50 million to $499 million, the average grew to 18 percent of their total operating expenses last year (versus 14 percent in 2016). The median, however, shrunk over the same period of time by 200 basis points to 11 percent, suggesting that some outliers are committing significantly more of their budget in this area than others. Meanwhile, the data also underscores that larger firms enjoy economies of scale in this area, and on average, allocate just 9 percent to professional fees annually, down from 13 percent five years ago. The blended average (12 percent) remained consistent with the 2016 benchmark.
Occupancy; travel and entertainment
Average occupancy as a percentage of costs dropped by two percentage points from 2016, in part reflecting the office space reset in the covid era. The blended average for 2021 was 8 percent, with slightly a slightly higher percentage for smaller firms (9 percent) and lower for midsize firms (6 percent). The covid effect also played a significant role in lowering the average blended T&E costs to 2 percent in 2021, down from 5 percent in 2016.
Surprisingly, technology and IT costs remained static over the past five years, and across all size levels, the blended average accounted for 3 percent of total operating expenses. This may speak to the relative consistency of SaaS subscription models. At the same time, however, it stands in contrast to the growing emphasis on data and speed documented in the aforementioned