Buyout Firms Face Life On Lower Incomes

Investors are planning a thorough pruning of the private equity industry after 18 months of weak returns, demanding managers put more of their own money at risk, in smaller funds, for smaller fees.

Remuneration should be based on reasonable operating expenses and salaries, some say, rather than the lavish fees that inflated as the industry grew in size.

Many also doubt the “financial supermarket” model buyout firms are adopting now that LBO deals have largely dried up.

“We are probably looking at a phase where private equity will go back to being relatively simple, more aligned and more focused on working companies hard,” said Wim Borgdorff, managing partner of private equity investor Alpinvest Partners.

Partners at big buyout houses like Blackstone, Kohlberg Kravis Roberts & Co. and Apollo Management are fighting to retain control of their future as belligerent investors take them to task.

U.S. firm TPG said this week it will return $20 million of fees to keep investors on-side, after previously allowing them to reduce their commitments by 10 percent, according to a source.

Investors Carried Away

Buoyed by returns coming thick and fast as private equity firms quickly flipped their investments, investors kept pledging more money to the asset class in the belief no one could lose.

This in turn drove up fund sizes and gave firms the green light to pursue larger deals, while expanding into new areas.

“We were probably all blinded a bit by the lights … we did get a bit ahead of ourselves,” said Alpinvest’s Borgdorff.

Investors like Alpinvest are now questioning the evolution of the industry — firms like Blackstone and KKR — into a publicly-listed asset manager model, offering private equity as just one element.

“There is very little evidence that model is superior to the simple one team, one fund setup we had before,” Borgdorff said.

Like hedge funds, private equity firms have built their remuneration structure around the “2 and 20” model of a 2 percent management fee and a 20 percent performance fee.

Alpinvest is a supporter of the Institutional Limited Partners Association (ILPA) principles which call for management fees to be based on reasonable operating expenses and salaries.

Also in its sights are transaction and monitoring fees, levied by firms for buying, selling and managing portfolio companies, which often come out of investor’s pockets.

KKR and Goldman Sachs charged $152 million in monitoring and transaction fees on U.S. discount store chain Dollar General, which filed to go public in August.

ILPA, which numbers some 220 investor organizations, is asking all such fees go to the fund, not just the private equity house managing it.

“This is not the ten commandments carved in stone, but it gives a strong indication of where we think we should go and what the important building blocks should be,” Borgdorff said.

Smaller Funds

“The thing that got out of whack were fund sizes — they grew irrespective of performance,” said one senior private equity partner who declined to be named.

As a result, the proportion of money staked by partners themselves has fallen as low as 1 percent, a level which if it were higher would keep fund sizes in check, the partner said.

These topics will be front and center when firms start raising their next fund.

Investors want funds to be on a par with the predecessor fund, not the one raised at the height of the cycle, putting buy-out funds back to he early-2000s, said Colin Wimsett, chief investment officer at fund of funds Pantheon Ventures.

(By Simon Meads)