Downward pressure on fees will make life very tough for badly managed firms in a downturn, according to Allan Emkin, managing principal at Meketa Investment Group, co-founder Pension Consulting Alliance. Emkin recently spoke with sister publication Private Equity International about how the industry has changed since he began his career almost three decades ago.
How are market dynamics shaping the discussion around fees?
“The PE fee model, which was developed in the late 1970s and 1980s, was intended to keep the lights on and profit was supposed to be in the carried interest. Because of increased demand, top GPs have been able to keep the same fee structures, even when there is no rationale for it anymore.
“Importantly, because of the extraordinary demand for premier partnerships, LPs not yet near their target will have limited ability to impact terms and conditions and partnerships. Meanwhile, funds with less compelling arguments are not getting the same fees, leading to a more fractured marketplace.
“Fee pressure and competition will make it more challenging for private equity to generate the kind of revenue streams they used to generate. In addition, investors/clients have become a lot more structured in their private portfolio construction and have focused on fewer GP relationships.
“The next time we have a significant recession there will be a shakeout in both public and private markets. In private equity, only those institutions that were really well-managed and capitalised will be able to successfully implement their growth strategies.
“Look at the big players, like Apollo, KKR, Carlyle and Bain Capital. They are good gatherers and know how to cross-sell. They have or are developing debt, real estate, credit and bank loan funds, even hedge funds, and are buying out whole teams to lead these programmes.
“The biggest private market fund managers will get treated differently and investors will have to pay whatever they demand. But significantly, a vast majority of private markets managers will not have that leverage, and that will lead to less competition. Eventually, this will not be a ‘win’ situation for most market players.”
We’re seeing increasing LP demand for co-investment. Do you see the dynamics around that changing?
“LPs want to improve fee structures in the market, and co-investments are a way to accomplish that. However, there is not an infinite supply of co-investment opportunities. Their availability is a function of the size of the transactions, and the funds that are investing in those transactions.
“It is hard to see any economic reason why GPs are willing to do co-investments; undoubtedly, a GP will choose full fee and carried interest as compared to very little returns, if any, on co-investments.
“One thing I can promise you is that big GPs are extremely talented and creative to figure out a methodology to make more money and generate more business; they will accomplish that objective in co-investments as well.
“But LPs are also collaborating, and these will increase. Big institutional investors that have the resources to develop new and innovative ways of deploying capital will commit resources to do that – whether that’s forming partnerships, putting together club organisations or GPs coming up with a group of LPs that are treated differently.
“LPs will do whatever they can to improve the alignment of interest and terms and conditions of partnerships but will be limited by demand and supply.
“LPs need to understand better the legal structures to operate in this market. They should actively support ILPA so that there is more information and more consistent reporting from GPs. That will help LPs develop a highly-informed and knowledgeable base from which to negotiate terms and conditions.”
To read the full interview on PEI, please click here.