Cost disclosure overhaul

Investors should adopt the standardised fee reporting template for private equity released by the Institutional Limited Partners Association, according to Mike Heale and Andrea Dang from CEM Benchmarking. Their research shows that it is not possible to get complete costs from current statements alone, with important costs buried by GP’s statements. CEM encourages all pension funds to adopt the ILPA fee reporting template by asking all GPs to report in this format.

Private equity is an increasingly important asset class for many pension funds. Private equity holdings of US public funds have doubled from 4 per cent to 8 per cent of total assets over the past 10 years in the CEM database. However, private equity firms have received sharp criticism of late for the lack of transparency and understatement of full costs in investor financial statements. CEM research concluded that less than half of full private costs were reported by pension funds in 2012 and 2013.

To further examine this problem, CEM was commissioned by a group of leading global funds to study how private equity costs are reported to limited partners (LPs). The goals of the research were to estimate the full cost of private equity and its components to determine whether full costs can be obtained using financial statements provided by general partners (GPs).

CEM received 2014 financial statement data for 147 private equity partnerships from 15 client funds. There were 126 direct limited partnerships and 21 fund-of-funds. Total commitments were $455 billion, and total net asset value (NAV) was $238 billion. Vintage years ranged from 2000 to 2014, and primary geographic regions of investment were US at 40 per cent and global at 31 per cent.

CEM concluded from this study that partnership financial statements rarely provide enough consistent and detailed cost information to estimate full costs. As a result, it is not possible to get complete costs from current statements alone.

Size of total PE cost and components

Using a combination of the CEM database and the financial statement review, we estimated the total cost of investing directly in private equity was 380 basis points on a fees-paid basis (management fee basis – typically total commitments during the investment period and invested capital post-commitment period) or 571 basis points based on NAV (partnership’s current value). Fund-of-fund costs were higher due to the additional top-layer manager fees: 173 basis points on a fees-paid basis or 217 basis points on NAV.

Gross management fees accounted for almost half of total private equity cost, while carried interest was about one-third of total private equity cost. Regarding the amount of carried interest, the limited time period of this study introduces potential bias because private equity returns are highly positively correlated with stockmarket returns. However, we would still expect carried interest to be a large portion of total cost over a longer time period.

Findings on financial statement transparency and consistency

CEM found that extracting the appropriate figures from the statements can be very difficult and time-consuming. The format and wording across statements varies and is not standardised. Important cost information is buried in the notes to the statements. These deficiencies, and especially those described below, impede understanding and identification of true costs.

Treatment of management fees

The financial statements perpetuate the industry myth that management fees are reduced by fee offsets (charges to portfolio companies that are shared by the GP and LPs). The table below demonstrates that the actual LP cost is 189 basis points versus the 143 basis points that is typically reported.

Thirty-one per cent of limited partnerships did not even report gross management fees, thereby implying that the net management fee is the only cost that matters. CEM believes reporting net management fees is misleading because the GP receives compensation equal to the gross management fee plus their share of fees eligible for offsets.

Inconsistent reporting of carried interest

Carried interest was usually reported on an accrual basis, although the basis was indeterminate for 21 per cent of statements. Also, carried interest was not reported in the same format across statements. Some partnerships had a separate account balance that tracked carried interest while some statements only had carried interest detail in the notes to financial statements.

Partnership expenses and transaction costs

Partnership expenses include professional, administrative, accounting and other fees. These were higher than expected and varied widely across partnerships, ranging from 5 to 106 basis points. In addition, categories for partnership expenses were vague in some cases with some partnerships reporting only two categories of expenses – professional and other.

Transaction costs were excluded from our analysis because they were identifiable in only 6 per cent of statements. Dutch funds are required to report PE transaction costs. CEM data from Dutch funds in 2014 suggests transaction costs average 32 basis points.

The solution – the new ILPA fee reporting template

The only way to get full private equity costs is by asking the GPs directly. A growing number of LPs are asking GPs to complete bespoke cost templates. Some pension funds are invested in hundreds of partnerships. This is an inefficient and problematic solution for both LPs and GPs.

Fortunately, a good global solution is now at hand. The Institutional Limited Partners Association (ILPA) recently released a new standardised fee reporting template. Several leading pension funds, interested industry firms, and CEM participated in the ILPA working group for this initiative. The template development process featured extensive global consultation and feedback from LPs, GPs, industry associations, and other interested parties.

The template features a lot more than cost information. It includes important management, control, and fiduciary information. For example, it has an interesting section that summarises all “GP and related party compensation”.

The cost information in the template is standardised, detailed, and complete. Six line items contain the cost information needed to report and benchmark total cost and its major components: gross management fees; accrued carried interest; total partnership expenses; and capitalised transaction fees and expenses.

Now it needs to be adopted. CEM encourages all pension funds to adopt the ILPA fee reporting template by asking all GPs to report in this format.

Full cost disclosure has many benefits for LPs:

• Better decisions – CEM research shows that PE performance is impacted by costs. Higher cost implementation styles, such as fund-of-funds, generate lower returns. A better understanding of true costs will lead to better decisions.
• Lower costs – understanding full costs can lead to reductions through negotiation with GPs. For example, a larger share of portfolio company fees is now distributed to LPs. Over time, the split has moved from a 0 per cent/100 per cent LP/GP distribution to about 85 per cent/15 per cent
• Reputation risk – stakeholders are increasingly demanding transparency and evidence that these costs are being managed.
• Fiduciary duty – LPs investing for others have a fiduciary duty to ensure that costs are reasonable and that correct amounts are paid. The amounts involved are huge.

Standardised full cost disclosure for private equity has arrived. You can find it on the ILPA website.

Carpe diem!

Mike Heale is a partner and Andrea Dang is a senior analyst at CEM Benchmarking.