Private Equity Funds - Promises, Promises; Fees, Fees

Private equity investment is no longer the preserve of the wealthy. New funds offer retail investors a taste of investment banking: putting money into unlisted companies to finance growth. The rewards can be great but, as a new survey from the Eureka Report reveals, so too can the fees; private equity remains richly rewarding for fund managers.
The listed end of the private equity market has blossomed in the past year, attracting more than $3 billion from investors. Several funds, including Allco Equity Partners, Babcock & Brown Capital and Macquarie Bank’s Macquarie Capital Alliance, now have about $1 billion each under management. These funds have been very successful in raising cash, but there has been little analysis of their fees.

Anyone considering investing in a listed private equity fund should look beyond the management expense ratios (MERs), which for most of newly listed private equity funds appear reasonable at about 1.5 percent, comparable with many conventional managed funds (see Table 1).

Be aware these fees apply only up to a returns benchmark set by the fund. Above that benchmark is where performance fees set listed private equity funds apart from most managed funds. It could be a publicly available figure, such as the ASX 300; more commonly it is an “in-house” benchmark designed by the fund manager. The benchmark for Allco Equity Partners, for example, is an internal rate of return of 15 percent.

Substantial performance fees are charged by all seven funds in our survey: Allco Equity Partners (AEP), Babcock & Brown Capital (BCM), Everest Babcock & Brown Alternative Investments (EBB), ING Private Equity Access (IPE), Macquarie Capital Management Ltd (MCQ), Macquarie Private Capital Group (MPG) and Souls Private Equity (SPEL).

The performance fees you should be aware of among our seven reviewed funds are:

1. Allco Equity Partners charges an incentive fee based on an internal rate of return (IRR). The fee works on a sliding scale. Above an IRR of 15 percent, Allco takes 25 percent as commission; when returns exceed 25 percent of the IRR, it charges 33%. Unusually, Allco applies its performance fees on individual transactions rather than across the board. This means it can still collect fees on successful transactions, even if it makes a net loss on its overall activities.

2. Babcock & Brown’s two funds, BCM and EBB, have an internal benchmark that is calculated each year, based on annualised total shareholder returns. A 20 percent commission cuts in when returns exceed the benchmark by 10 percent, and a 30 percent commission applies beyond 20 percent above the benchmark.
3. Macquarie Bank’s MCQ fund uses the ASX 200 accumulation index as its benchmark, and charges a commission of 20 percent on any returns above it. Its smaller MPG fund charges a commission of 20 percent of any returns above 10 per cent of an internal benchmark. The MPG internal benchmark is set 10 percent above average portfolio returns.
4. ING Private Access charges 10 percent of any outperformance of an ASX-related benchmark. The benchmark is 3 percent above the ASX 300 accumulation index, calculated over a three-year rolling period, or a commission of 25 percent of any outperformance of the same benchmark over the period.
5. Souls Private Equity charges a commission of 15 percent above its benchmark of an internal rate of return of 10 percent. Despite the reasonable level of performance fees, SPEL charges the highest management fees of any of the funds reviewed: 1.75 percent.

Are these fees justified? The answer is yes, provided the implicit promise of outperformance is realised over an extended period.

Most of the seven funds in our survey have, in recent years, built a strong record in private equity-style investing. If the managers can beat their benchmarks, most investors will accept the level of fees, although some might wince. Performance-based fees are now standard in the two key streams of alternative investing: private equity funds and hedge funds.

The question for most investors is not whether these fees are fair or reasonable, because they always have the option of putting their money elsewhere; it is more whether the funds can achieve the outperformance such hefty fees imply?

History suggests that only a minority of these funds will ever succeed.

Private equity managers must have strong expertise in their investment area to outperform in this heavily populated market. In 2000, stockbroker JBWere launched a private equity fund specialising in start-up companies. At that time, private equity managers were regularly reporting an internal rate of return of 30 percent, sometimes more, on private equity investments. Were understood private equity, but had little experience with technology start-ups, which were all the rage in 2000.

JBWere aimed to raise $100 million. As it turned out, the fund closed oversubscribed at $145 million. Among the luminaries attached to the fund were former National Australia Bank chief executive Don Argus and fund manager Bernard Stanton, who had managed the private equity interests of the multi-millionaire Darling family. The tech-heavy fund was wound up earlier this year after five years of exceptionally unimpressive returns.

It is unlikely that any of the seven funds reviewed here will be wound up with such conspicuous lack of success. For a start, most private equity funds are now very wary of technology investments. Figures from Thomson Venture Economics for 2004 show computer hardware received just $2.5 million of the $2 billion invested in private equity. Nevertheless, it is likely that some of the newly listed private equity funds will never make the sort of returns they implicitly promise.

In the listed private equity sector, the challenge of consistently making above-average returns may well be hardest for the biggest funds. In common with managed funds operators such as AMP or BT, which have always found it difficult to invest large amounts of money in the relatively modest reaches of the ASX, heavyweight fund managers such as Allco and Babcock & Brown will have trouble finding “big ticket” private equity investments in Australia in the years ahead; the bigger funds will almost certainly have turn instead to overseas markets and take on additional risk. In fact, the biggest investment yet made by this new group of funds is the $3 billion purchase of the British-based Yellow Brick Road directories business by Macquarie Capital Alliance (in conjunction with Macquarie Bank) on May 16.

A strong track record, even in the niche area of unlisted private equity, can only be a guide to future performance in the listed market. Although some of the managers in our review have excellent reputations, they have not built those reputations as managers of billion-dollar listed private equity funds because these funds are new on the ASX.

Many long-time private equity investors believe private equity by its very nature is best suited to non-listed funds. This is because the cycle in private equity is at least five years, and often as long as 10 years. Investments generally fare quite poorly in the early years of the cycle, and then hit high profitability in the final years. In turn, this cycle is explained by the intrinsic nature of many start-up ventures, where early revenues are not translated into profits until after a few tough years.

All seven funds in our review were floated in the past nine months, and almost all are trading below their issue price, in some cases by more than 20 per cent. Poor performance from the funds suggests investors have already sobered to the long-term challenges of private equity in Australia.

Allco’s Equity Partners fund, issued at $2, is trading around $1.37; the Babcock & Brown Capital Fund, issued on February 14 at $2.50, is now about $2.32; and ING Private Access Limited, issued at $2.00 on November 25 last year is trading around $1.70 (figures are for Sep 13 – see table below). On July 25, Allco Equity Partners made its first big move with a hostile $470 million takeover bid for the listed credit information agency Baycorp Advantage.

Adding further pressure on share prices in the listed private equity sector is a distinct threat that current tax advantages may be removed from some funds. Several of the larger private equity listed funds, including Macquarie Capital Alliance, Babcock & Brown Capital and Souls Private Equity, are categorised as listed investment companies (LICs).

Trading as LICs, these funds have strong advantages to top taxpayers because they pass on a capital gains tax discount to investors. Under a draft ruling from the ATO earlier this year, the positive tax effect could be withdrawn. In effect, the change would reduce the attraction of LICs. The changes are by no means certain, but analysts believe the spectre of the tax change has contributed to the easing in prices of listed private equity funds.

Assessing listed private equity funds in the light of high fees, a poor short-term trading performance and unclear tax legislation, investors will need strong nerves for the coming year in private equity, but the prospects of above-average returns will entice many deeper into the market.

ACTION PLAN

Remember, listed private equity funds are not the first option in private equity. Until very recently, the vast majority of investment in this sector was in non-listed funds.

However, if you prefer the liquidity offered by listed private equity-style funds, small might just be beautiful in the local market. Nimble funds with less than $500 million may have an edge over very large funds managing $1 billion or more.

You will have to take high management fees in your stride. Among the biggest performance-fee chargers are Allco, Babcock & Brown and Macquarie Bank. You will also have to take on board a certain level of market volatility and tax uncertainty.

There are several funds to choose from on the ASX, although three dominate, having raised about $1 billion each: Allco Equity Partners, Babcock & Brown Capital and Macquarie Capital Alliance. These three charge similar fees to smaller funds.

Smaller funds of less than $500 million, such as Everest Babcock & Brown Alternative Investments, ING Private Equity, Macquarie Private Capital and Souls Private Equity, should be in a much better position to pick investment opportunities in their price range. The only drawback for the smaller funds will be an inability to do very big deals on their own.

Substantial discounts are available on many listed private equity funds in the second half of 2005. Some funds are trading at more than 20 percent below their issue price. If you want to get into this investment area, consider buying a small fund trading at such a discount.