Karabo Nkoana, Senior Investment Director at Ke Nako Capital & Thuso Partners

No pension fund trustee can ignore the question of fees. Whatever investment managers are charging must be reasonable, and justified.

Most trustees are comfortable making these judgements in the listed space. However, evaluating fees in private markets products can be a lot more complex.

This is, firstly, because they are not directly comparable to the fees charged by traditional and even hedge fund managers. Private equity fees can appear high in relative terms, but the fee structures are entirely different.

Most significantly, most private equity vehicles will charge fees on capital commitments during the investment period, but in essence they will pay all of those back at the end of the fund’s life. When capital gets returned and return hurdles need to be met that are net of fees, whatever investors have paid in management fees will be returned to them.

Secondly, private equity vehicles don’t charge ongoing performance fees. While listed managers, particularly in the hedge fund space, will calculate and charge a performance component accrued daily, private equity funds only charge a once-off performance fee at the end of the life of the fund.

Importantly, these final fees are charged according to a distribution waterfall. The fund managers will not earn any performance fees until investors have received their full capital back plus the hurdle rate, which is the agreed minimum rate of return. Generally, this is around 10% per annum. The performance fee is only applicable to returns above that mark.

The same considerations are true when thinking about private equity fund of fund vehicles. While there is another layer of fees charged by the fund of funds manager, these too are paid back at the end of the life of the fund. Performance fees, again, are only charged once-off, and only on returns above the hurdle rate.

It’s also worth considering what an investor gets for what they are paying in a private markets context. There are a lot of “frontloaded” costs due to the nature of the investments that managers have to bear. The due diligence, legal and contracting work required upfront when entering into an investment and ensuring the protection of shareholder rights are significant, and require high levels of expertise. The ongoing monitoring of any investment also requires substantial time and proficiency. In addition, a large part of the value that private equity brings is the expertise to increase business efficiency, scale effectively and really unlock value for shareholders.

These factors are not only at play at the single manager level, but also for a fund of funds manager. Trustees may question why it makes sense to pay another layer of fees to a private equity fund of funds when they could, theoretically, simply allocate to individual managers themselves. But there are a lot of nuances to this process.

Firstly, conducting due diligences and the ongoing monitoring of the underlying managers and how they allocate capital come with a high governance burden. These require specific, and rare, skills that would be both expensive and difficult to find and retain in-house. Fund of funds managers are also imbedded in the industry, with institutional memory and extensive networks, with deep trust built with managers over multiple vintages.

At Ke Nako Capital, for instance, we have access to managers that other investors may not be able to get exposure to. These are both managers outside of the better-known names, as well as certain managers who simply do not want to deal directly with institutional investors. The lessons we have learnt through multiple iterations become valuable to the managers we partner, and this symbiotic relationship provides us with access not typically available to others.

For this group, the benefit to them is that instead of dealing with numerous limited partners, they have a much smaller client set if they restrict access to fund of funds managers. This allows them to focus more time on their core job of sourcing deals and generating returns.

At the same time, the benefit to pension funds is that instead of having to deal with a range of different managers, they have a single point of contact with the fund of funds manager. One practical example of the benefit of this is that during the drawdown phase, a pension fund may have to manage drawdown requests from a dozen or more different firms. But if they are invested through a fund of funds, they will only receive a single request that consolidates all the others.

Similarly, the fund of funds manager can also offset distributions against capital calls within the structure. That reduces the administrative burden on the pension fund.

Fund of fund structures also allow for more holistic portfolio construction ensuring that the allocation across managers builds a diversified portfolio of top quartile managers. They also allow for the inclusion of return-enhancing and fee-reducing co-investments where these are available. The skillset required to both select top quartile managers, and include high conviction co-investments is what makes the difference between simple allocation and top quartile performance in a diversified private equity portfolio.

In a complex environment, this is highly valuable. It highlights that while there is, rightly, a lot of focus on fees, trustees need to think not just in terms of the level they pay, but also what they are getting.

Due to the long lock-in period, private equity is not a space where you want to take a risk on under-resourced or fly-by-night managers. Expertise in this environment is worth paying for, and is evidenced in superior returns.

Ed’s note: Grow your understanding of private markets from those in the know in EBnet.Stream’s podcast series: Inside Private Markets here. 

ENDS