Private equity performance fees are a growing source of consternation among Dutch pension funds where some have been stung for billions in fees despite beneficiary payments lagging roaring inflation and Europe’s cost of living crisis.
“Private equity fees are a difficult topic,” admits Harold Clijsen, chief executive of PGB Pensioendiensten, pension provider for Pensioenfonds PGB (PGB), the Netherlands €34.8 billion ($35.2 billion) industry-wide pension fund.
PGB targets a 7.5 per cent allocation to private assets of which only 2.5 per cent is in private equity, focused on European and US small and mid-cap buyouts.
That relatively small allocation means PGB’s current total fee spend across the whole portfolio is only 43 basis points, well under its maximum permitted budget of 55 basis points that must include all transaction and performance fees, and which shapes a highly selective budget allocation.
But other funds are suffering a much bigger hit. Civil service pension fund ABP, one of the biggest pension funds in the world, paid €2.8 billion ($2.84 billion) in costs to private equity funds last year yet has only recently increased beneficiary payments for the first time since 2008.
Elsewhere, the €277.5 billion ($281.3 billion) healthcare scheme PFZW paid €1.26 billion ($1.28 billion) in performance fees to its private equity managers in 2121, equivalent to two thirds of total asset management costs thanks to private equity’s 2-20 model comprising a fixed 2 per cent management fee and a 20 per cent performance fee.
Clijsen is supportive of fixed fees (especially for smaller private equity mangers) arguing they are an important element to successfully running investee companies.
But he questions performance fees particularly given limited partners’ ability to drive them down when so many investors are chasing illiquid allocations.
“The problem is the performance fee which kicks in hard,” he says. “But we don’t have much pricing power because all the money in the world is looking for profitable investments.”
For now, he’s still convinced private equity is worth the cost because of the returns.
“In the end you have to consider net return after fees and last year’s performance showed private equity does add value to the portfolio.”
Still, strategy at PGB is shaped around lowering the fee spend wherever possible including prioritising re-ups in funds PGB is already invested in to cut out the advisor fee, as well as co-investments beside fund managers and with other pension funds to lower the fees attached to advice and monitoring.
PGB’s growing scale also works in its favour. Back in 2005 PGB only invested on behalf of one industry fund. Now it represents 4,000 employers across 16 different industries and assets under management have grown to €34 billion from €11 billion.
“We are large enough to be an interesting client,” says Clijsen. “Our partners know we are there for the long run and this makes us attractive to do business with. We also tend to invest in follow-up funds but that said, when a large part of the team or key personnel leaves the company, that could trigger a change of mandate.”
Clijsen rules out developing an internal private equity team even though PGB runs its matching portfolio inhouse and he believes inhouse management is the most effective solution to high private equity fees. All the return-seeking allocation is outsourced, and PGB would struggle to compete for private equity talent; investing in European and US private equity also requires a team on the ground, he reasons.
Return seeking allocation
Away from private equity, other corners of the return-seeking allocation are also attracting his attention. He is concerned about the impact of stagflation crimping growth in the listed equity allocation and impacting beneficiary pay-outs.
“We need returns from equity and other assets in order to grow capital and achieve indexation. When inflation is high, people expect to get compensated because of the increased cost of living. But increasing compensation is difficult in a recession or zero growth environment. We were able to increase pensions with 3 per cent this year.”
One approach designed to cushion the portfolio from falls in equity include an equity hedging strategy using options to protect the downside.
“When equity is more expensive in relation to yields and momentum turns negative, we do hedge some equity risk. When equity drops, this adds a little on the return side; the idea is to protect capital and therefore the coverage ratio,” he explains.
Elsewhere in the liquid allocation, PGB is prioritising passive market weight and equal-weight strategies in combination with more quant-driven strategies like factor investing in order to gain additional return.
“We want a consistent approach to liquid markets on one hand and on the other we want to cut costs. At this moment, we are looking for more cost cutting through developing our own strategies for selecting equities.”
The fund’s assets are split 60/40 between the return and matching portfolio respectively. Although rising interest rates and inflation are concerning in the return seeking allocation, they have buoyed the matching portfolio where PGB’s coverage ratio is currently 120 per cent.
The internal team also run a dynamic risk hedging strategy whereby when interest-rate risk is low, the fund calculates a lower risk budget and reduces its interest rate hedge; when rates move higher it increases the hedge.
At the start of the year around 45 per cent of the liabilities’ interest rate risk was hedged, but this has now risen to around 65 per cent on the prospect of further hikes but where decision making also balances the threat of recession – and lower rates.
“There is still an upside in interest rates because if inflation doesn’t come down, rates will rise further,” he says.
After eight years as PGB’s CIO, Clijsen became chief executive in 2020 turning his hand to new tasks like conversing with corporates looking to move their pension management to PGB and gauging the impact of local developments on the total organisation. One element he finds interesting is the impact of legislation on pension fund management, particularly new rules set to encourage beneficiary engagement, encouraging DC investors to take more control of the investment process.
“Beneficiaries now have choices on risk appetite; how they think about ESG and which investments we should make for them,” he says. PGB already runs extensive questionnaires, group-interviews on risk budgets and ESG-polices and has introduced a digital tool which helps participants set their own risk budget.
It’s a shift that he predicts will force Dutch pension funds to adopt more transparency around their investment process, holding consequences for trustees and boards unable to adapt that could result in PGB accruing more assets under its stewardship over time.
“I expect more consolidation in the sector. We are prepared to take on more pension plans for employers who want to outsource to a professional, social, pension fund,” he concludes.