The end of ‘2-and-20’?

The challenge:  

More and more sources are telling us that the prototypical 2-and-20 fee structure will soon be a thing of the past. We’re skeptical, but challenged Augentius managing director Brendan Tyne to explain why it could happen.

Brendan Tyne’s response:

Sometimes it’s hard to move away from things that have become standard and routine. But sometimes those things we cling to most fervently are the things we need to let go of the most. The private equity industry is approaching that point with its standard “two and 20” fund fee and carry structure.

The move away from this standard fee and carry structure will likely follow the current changes taking place in the hedge fund space. Here’s why: large LPs are examining their relationships with GPs, in many cases whittling down the number of firms they invest with. While demand is still great, competition is still fierce for LP investment. It stands to reason that the basic fee and carry structure will be under discussion as well.

In some ways a precedent has already been set by the hedge fund industry. The hedge fund world grappled with the fee and carry several years ago and by the end of 2013 the Financial Times declared the two and twenty “long dead and buried” in the hedge fund industry. The hedge fund industry had its own bout of being portrayed as the world’s leading financial villain and was put through the rigors by its own investors, who demanded change.

Private equity has in some ways followed the hedge world’s lead and will likely to do so here in its own way. Where it differs is that the performance pressures on the hedge world were pushing down fee and carry rates, while the private equity world has a better performance record to stand on and defend the status quo. The hedge fund world took in lots of money from investors and when returns were lagging, it had to make those changes.

Returns aren’t lagging for private equity LPs like they were for the investors in the hedge world a few years ago. Private equity funds have a longer track record with large institutional investors, including pension funds that have still avoided the hedge fund world.

While private equity has performed consistently well and above market rate, the demands of disclosure and fee criticism have grown more intense for private equity and the large investors know they have the sway to make changes in the market.

With the pressure on large public LPs over the level of fees being charged, these investors will likely start pressuring more private equity funds to reduce the going fee and carry. Once these large limited partners begin setting precedents with lower fees, it will become the new standard.

The two and twenty has already been chipped away in some private equity funds, though some of the larger and more prestigious have been known to charge well more than that. Those firms that go above the “two and twenty” standard are a rarity. It’s more likely to find funds that give the larger LPs a break or even waive some fees with a higher carry agreement.

Online market places are bringing retail investment into the private equity space as well. Will these platforms replace private equity funds? Of course not. The industry has positioned itself with expertise and winning growth strategies that you can’t download from a web server. But the lower cost options will undoubtedly add to the overall picture to help push private equity fees further onto a downward slope.

There won’t be an event horizon that sends the private equity fee and carry structure tumbling. Change will come slowly, but the writing is on the wall. The days are numbered for the standard “two and 20” in private equity.