A fair day’s wage for a fair day’s work

The investment world has long been divided into two opposing camps – fund managers seeking the highest fees they can possibly get away with and investors in search of the lowest. 

When it comes to private debt funds, however, investors aren’t necessarily searching for bargain basement fee arrangements, they simply want to know that the fees they are paying are justified.

Just because institutional investors have become accustomed to paying two and 20 fee structures to hedge funds and private equity, it doesn’t mean they will automatically do so for every opportunity. 

With lower returns and longer lock-ups, it should come as no surprise that the two and 20 model is not the norm for private debt funds, rather it is the exception. Management fees of 1-1.5 percent and performance fees of 10-15 percent have become commonplace – with fees charged only on invested capital as opposed to committed. And, regardless of the particular management and performance fee combination, virtually all fee arrangements now include a hurdle rate, with many also containing clawback agreements. 

But perhaps the major difference from other alternatives is that it is not necessarily to the biggest and most recognisable firms that investors are willing to pay the highest fees. 

“Even though on a relative basis you will probably make more money in these private funds because you’re getting some sort of an illiquidity premium, returns are still down considerably from several years ago. So, fee structures have to be looked at a lot closer now,” says the chief investment officer of a $6 billion private foundation. 

“If you’re getting a 20-25 percent gross return, then a 1.5 and 20 or two and 20 fee structure doesn’t necessarily look bad. But when you’re only getting a gross return of 12 percent, and then fees take you down to 7 or 8 percent, to us that’s not an acceptable rate of return for the illiquidity premium,” he says, adding that being compensated for illiquidity is a bigger concern for foundations like his with closed pools of money than it is for public funds. 

Since it can take up to two to three years for capital to be put to work, and debt funds are providing seven- and up to 10-year loans, gains take time to be realised. Given this reality, investors are taking a page from the private equity playbook and looking beyond the internal rate of return to measure overall return on capital. One increasingly common way to protect overall return prospects is building hurdle rates into investment agreements. 

“A hurdle rate with a transparent calculation of aligned fees and the timing of the calculation of those fees, can make a real difference and make those investments more compelling,” says Jenny Chan, chief investment officer of the Doris Duke Charitable Foundation. 

Instead of hedge fund-like calculations where fund managers are paid as soon as a high water mark is reached, she says managers of longer-term direct-lending funds would be better to forego fees for a set period, whether or not the hurdle is reached, to better align manager and investors’ interests through the way fees are calculated. 

Investor friendliness is a concept repeatedly emphasised by private debt fund investors. And being investor friendly doesn’t necessarily mean offering the lowest fee structure. 

“Post-2008 we’re seeing that people are willing to provide managers with the terms and conditions that are appropriate and necessary for their business and for their investment strategy,” says the senior adviser for a $200 million firm who has been structuring terms for the firm’s private debt funds. He thinks firms that structure LP-friendly investment terms and provide attractive investment strategies are unlikely to be pushed for lower fees. 

“Our seed investors know that in order for their investments to do well our business needs to be stable and that we need to be able to pay the bills and to attract and retain bright people. Therefore, they’re willing to pay us what I’d call commercial fees without focusing on trying to squeeze an extra 5bps, 10bps or 15bps or a 5 percent carry out of our proposal,” he says. 

When it comes to being investor friendly, he adds that his firm is going out with a 1.5 and 10 fee structure, with a catch-up and plus carry over an excess hurdle rate. If the firm hits 10 it will take its carry, which then resets to zero. Any return over the mid- to high-teen excess hurdle means a kicker of 15 percent on top of the difference between the standard and excess hurdles.

Where he expects that investors will push back is with the big credit and event-driven shops that have suddenly decided to move into private debt and expect to charge the same two and 20 fees they have traditionally charged for funds where they have proven expertise and long-term track records. 

For Thomas Heck, chief investment officer for the Ball State University Foundation, while he admits that it is important to be aware of fees and to try to negotiate the most investor-friendly terms possible, he agrees that simply chasing the lowest fees isn’t necessarily the best approach investors can take. “We’re required by the Uniform Prudent Management of Institutional Funds Act to manage our costs and make sure they’re prudent. But we’ve also got the other pressure to earn returns. So whatever we need to do to earn returns we’re kind of required to do that as well,” says Heck, adding that the result is a constant push and pull in the foundation’s investment committee discussions. 

“We often find ourselves saying, ‘Okay, it’s really great to do low fee kinds of things, but there are fees you really do have to incur in order to try and achieve the returns you need for your mission’.”

While the reality that fees may be an unavoidable and necessary evil, that doesn’t mean that investors will simply accept fund managers’ fee proposals as being in stone. “Where we are now in the world, a lot of investors are more discerning,” says Sam Martin, a senior analyst with SCS Financial. 

Just as performance hurdles have essentially become the norm for private debt funds, he says that clawbacks are another tool investors frequently rely on as a way of ensuring they will get the best possible returns. “If a firm doesn’t have a long track record, not only will we usually put in a hurdle like Libor plus 5 or 6 percent, but we’ll often add a clawback provision as well. That way, if they crystallise the performance fee after the first year, but are down the next year, we can claw back some of those performance gains,” says Martin. 

Another tool he says firms like his frequently use are clauses stating that if another investor comes in with lower fees they too will get the same rate – though he notes that this can be easily circumvented with separately managed accounts. 

At the end of the day, as with any other type of investment, the stake an investor is willing to take plays a large factor in the fees they receive. 

“Size is a major factor,” says Martin. “How meaningful a position you are in a fund determines what your power of negotiation is.”