“Private debt fees on the slide” was one of the headlines greeting readers on 16 May as PDI reported on a survey that found European direct lending funds had seen their management fees drop by an average of 30 percent since 2015.
The median management fee for these funds fell from 150 basis points to 100bps, with the average carry percentage declining from 15 percent to 10 percent, according to the Investment Management Fees: New Savings, New Challenges report by consultancy bfinance.
Stephanie Berdik, a partner in the corporate department and a member of the private investment funds group at law firm Proskauer in Boston, points to the history of private debt as a clue to the present. She says that in the early days of the asset class most allocations came from private equity buckets – as a result of which, management fees of 2 percent and carried interest of 20 percent were commonplace, as that’s what these investors were used to paying.
However, more recent allocations are increasingly coming from fixed income buckets. “These investors are coming to private debt for exposure to senior debt type funds – they are not looking for mezzanine or distressed – and they are looking at fee structures through a very different lens,” says Berdik.
If fixed income emigrants raise an eyebrow at private equity-type fees, this should come as no surprise. After all, the economics of private debt funds vary depending on the strategy – and senior debt funds (particularly unleveraged ones) are at the lower return end of the spectrum. With projected returns of typically around 6-8 percent, fees and carry will normally be no higher than 1 percent and 10 percent respectively (with some market observers saying they have seen management fees as low as circa 0.5 percent).
Leveraged funds, particularly those with some exposure to unitranche, might expect fees and carry to rise to 1.5 percent and 15 percent respectively, while those targeting mezzanine and distressed may still be able to charge 2 and 20, although this would be at the higher end of expectations.
Berdik points out that higher fees may also be charged by first-time funds. “The management fee needs to keep the lights on and, as a first-timer, you need to build a team at the same time as running the fund. In these cases, 2 percent may be appropriate as they may need to charge that just to keep going.”
In addition, as in other asset classes, private debt has seen a so-called ‘flight to quality’ with certain trusted fund managers finding life on the fundraising trail much easier than many of their peers. These managers may also be able to charge 2 and 20. However, Berdik says that even they will need to demonstrate that they are not using the fee as a profit centre.
Berdik says that, although the bfinance survey indicated a fairly steep drop in fees for European direct lending funds, she would expect even more pressure on fees in the US. “We see similar trends on both sides of the Atlantic but, if anything, the US mid-market is even more crowded than Europe and that could drive fees down more. The pool of available investments is getting smaller and smaller.”
It’s worth noting, however, that alongside this pressure for lower fees has come some pushback – or negotiation – from fund managers. For example, market sources say some will agree to lower carry in exchange for getting paid sooner. With the typical European waterfall structure slow to pay out, funds have been negotiating a structure somewhere between the European and US versions – the latter “deal by deal” version triggering carried interest payments quicker.
COMPETITION UP, FEES DOWN
Alex Amos, a partner at law firm Macfarlanes in London with a particular focus on real estate and credit funds, agrees that fees have come down overall – but, whereas Berdik’s explanation is rooted in the history of shifting asset class allocations, he believes it’s simply to do with increasing competition.
“Target returns coming down will inevitably have an impact on fees,” he says. “There are many more players and it’s increasingly a borrowers’ market.”
The figures back up Amos’s suggestion of a more crowded market. In the first quarter of this year, private debt funds raised $31.2 billion in capital, according to PDI’s Q1 2017 Fundraising Report. This made it the most prolific first-quarter for fundraising since 2008.
However, he points out that the larger players will make up for smaller fees on individual funds by launching a range of strategies. “What they lose on fees, they make up for in scale,” says Amos. “They have all sorts of bolt-ons that boost fee revenues so they can make the model work even though fees have come down compared with five years ago.”
Amos makes the point that there is little evidence of fund managers offering lower fees in a race to the bottom. Nonetheless, the bfinance survey clearly shows some ground has been given as investors push for what they see as appropriate balance of return and reward.