Only a few years ago, established sponsors could raise new PE funds with little resistance to the traditional 2 and 20 economic model. While PE funds continue to raise money, the heady days appear to be over, at least for now, and the pendulum appears to have swung away from sponsors and in favour of investors. This shifting paradigm has resulted in a number of investment models or approaches.
Pressure on Sponsor Economics
There has been overall pressure on the quantum of “base fees”, being annual fees, often calculated with reference to either capital commitments or invested capital (or some combination of the two). Such pressure has resulted in reductions to as low as 1%, or sliding scales depending upon fund or investor size. In some segments of the market, there has been a more philosophical attack on base fees as being representative of a misalignment of risk/rewards.
Sponsors have also been pressured on the carry aspect of sponsor economics. In some cases, the pressure has focussed on whole-of fund carry calculations rather than deal by deal, while in other cases the pressure has focussed on higher hurdle rates or lower carried interest percentages.
In an effort to ensure that PE funds attract sufficient capital from investors, it is becoming more common for sponsors to develop fund structures that accommodate multiple base fee calculation methods, with different groups of investors paying different fees based on their preferred fee model.
Finally, investors have increased scrutiny on fees receivable by sponsors and their affiliates, often demanding full management fee offsets.
Canadian pension funds have long been world leaders in direct investments. Some of the early leaders in this area continue to be active but have now been joined by some of the other parts of the very large pension fund fraternity. The increase in direct investment typically comes, in part, at the expense of investing in funds. However, a number of pension plans have indicated that they will continue to invest in funds as part of their overall investment strategy, at least for the purposes of obtaining co-investment opportunities.
While at this point, lacking the investment infrastructure of their larger brethren, medium and smaller pension funds have also indicated an increasing appetite for direct investing. This appetite has been manifested through a combination of bespoke fund investments and the formation of consortia, or clubs, of like-minded investors.
Some pension funds are wholly or in part abandoning the PE sponsor model, choosing instead to retain asset or investment managers. Pursuant to this model, compensation is typically based on a fixed percentage fee, often declining as assets under management increase. While increasingly there may be some sharing of upside, it is a far cry from the 20% carry that is typical of traditional PE funds.
Absent a crystal ball, it is difficult to predict as to the future of institutional investing. No doubt it will be influenced by a variety of factors. However, it is clear that some institutional investors are actively considering whether the traditional PE fund model suits all, some or none of their needs.