Private equity funds have long been characterised by high fees. Even as the number of asset managers (general partners or GPs) offering PE funds increased steadily over the past few decades, competition for the attention of limited partners (LPs) did not lead to an immediate shift in the cost of mandating specialist managers to buy and sell private companies.

Recently however, as reported on top1000funds.com in the article Investor pressure on fees, years of pressure from asset owners has led to a seemingly ineluctable trend towards fewer and lower private equity management fees.

The fact that increasing competition did not immediately lead to lower costs, when these were high to begin with, is an interesting puzzle.

Economists would see a case of strong information asymmetry between buyers and sellers, combined with a case of “type pooling” – in a market where some managers are capable of delivering a high quality service at a fair price (type A) but most are not (type B), both types of manager can tend to “pool” together and offer the same low quality product at a high price. Competition fails. This common phenomenon (think “finding a good plumber”) is the result of information asymmetry: clients cannot tell beforehand which service providers are of type A or type B.

Fee levels are only a consequence, or a symptom, of information asymmetry between GPs and LPs.

High fees had been acceptable to LPs thanks to high reported returns. But as the recent decisions by CalPERS or NYCERS to pull out of hedge funds altogether illustrate, lower returns in recent years have made fee levels much harder to justify in alternative strategies.

Reported excess returns in hedge funds or private real estate are lower in part because they are better measured: valuation methodologies and available data have improved sufficiently to allow quasi-market valuations to be reported.

Hence, out-performance measurement has become more accurate, and also lower because a greater proportion of hedge fund or private real estate performance can now be understood as a combination of market betas.

The evolution of asset pricing techniques and data availability has led to more accurate risk-adjusted performance measurement, and to a re-evaluation of the benefits received by LPs from delegating investment decisions to a hedge fund, or private real estate manager.

In other areas of the alternative universe, private asset valuation remains a source of significant information asymmetry between GPs and LPs.

For very illiquid and thinly traded assets, such as infrastructure, investment returns continue for the most part to be reported on the basis of quarterly or annual appraisals, which leads to a number of well-known issues: stale pricing, return smoothing and the impossibility to estimate the true diversification contribution of such assets in the absence of reliable measures of co-variance.

When assets are valued by discounting 25 years of future cash flows, the choice of cash flow scenario and discount factors explains most of the reported performance. In the absence of robust cash flow forecasting and discounting techniques grounded in financial theory, the entire reporting exercise amounts to a set of ad hoc and often opaque assumptions.

Nor is this news to asset owners.

In a new EDHEC Infrastructure Institute/Global Infrastructure Hub survey of institutional investors’ perceptions and expectations of infrastructure investment, less than half of respondents declare trusting the valuation reported by private infrastructure asset managers. A quarter declared not knowing whether or not they can trust them, and a little more than a quarter bluntly reports not trusting reported NAVs in infrastructure PE funds.

Today, in the infrastructure and other very illiquid asset classes, reported returns are also somewhat lower because new investments are being made at higher prices, and the pressure from LPs to lower fees is on.

But bludgeoning service providers into charging lower fees (sometimes with the help of the regulator), without asking them to provide better service, does not solve the market failure identified above.

 

Are asset owners condemned?

Those who pull out of delegated investments can either abandon an asset class altogether (no more hedge funds!) or try and internalise the skill set.

But in both cases this creates opportunity costs from lower diversification with – and within – the asset class (you cannot replace 20 asset managers with one internal team). In the latter case it also creates direct costs.

Furthermore, private investment teams operating within asset owners still mostly report the same stale NAVs and IRRs, while those who will stick with private asset managers who can only charge low fees (because the regulator said so) may now be faced with 100 per cent of type Bs.

So are asset owners condemned to maneuvering between the Scylla of DIY private investing and the Charybdis of opaque and expensive delegated investment in private assets?

There are solutions to minimise the effect of information asymmetry in market dynamics. To avoid the pooling of manager types, market participants can create “sorting devices” or “revelation mechanisms” to facilitate the processing of information from uninformed to informed participants.

In economics, this problem is typically modelled as a “market with adverse selection and competitive search”, where some agents post terms of trade (term sheets) and others aim to screen the other side of the trade by agent type.

In such models, the informed side of the trade (here the asset manager) can move first and signal to the market what terms they can offer, or the uninformed side (asset owners) can move first and request bids for a discriminating “menu” of potential products or investment solutions, which includes items that only type A managers can deliver, prompting type Bs to exit this segment of the market.

Hence, beyond the debate on fees, the need to better discriminate between private asset managers should lead asset owners to require better reporting, better valuation techniques and better risk-adjusted performance measurement.

Their next battle will logically be to improve the valuation framework of private assets and move away from reporting single IRRs and towards a fully-fledged factor decomposition of returns. In fact, CalPERS did keep one hedge fund manager on its books, the only one that could offer a hedge fund strategy defined in terms of alternative betas.

Still, it should be noted that solutions to problems of information asymmetry always involve the uninformed side paying an “information rent” to the informed side for revealing its type.

In other words, asset owners should not expect to get type A managers on the cheap. It remains in their best interest to try and discriminate between them and the rest, because it can lead to the cheapest outcome for a given level of risk-adjusted performance.

Finally, given the recent trend on fee levels in private equity, it is also in the best interest of type A managers to signal very clearly that they can deliver better measured out-performance by adopting more transparent and useful performance reporting standards, and valuation methodologies that are better adapted the nature of the information available about private assets.

Frederic Blanc-Brude is the director of EDHEC Infrastructure Institute-Singapore and EDHEC Business School Asia-Pacific

When Anne Stausboll started her role as chief executive at CalPERS it was a tumultuous environment, or what she calls a “perfect storm”. It was January 2009, the markets were in crisis, there was a state budget crisis in California, and CalPERS was facing ethical issues relating to the fund and former employees.

“My focus was on restoring trust and credibility to the organisation, and making it transparent and open,” she says.

Where historically the culture at CalPERS had been built around its size, and the large size of its portfolio; Stausboll has been focused on rebranding CalPERS around a public service organisation.

“We are here to serve others who have served California,” she says. “This has brought the organisation together, and it is very unifying to brand around that.”

CalPERS is a big business, and the role of CEO is immense. CalPERS administers retirement benefits for more than 1.8 million California public sector workers and oversees an investment portfolio of approximately $300 billion. CalPERS also purchases health care for nearly 1.4 million members.

And this means Stausboll oversees around 2,700 employees and an annual budget of $1.8 billion.

“When I started my job as chief executive in 2009, CalPERS had been here for 75 odd years,” she says. “One thing that struck me about the organisational structure was we didn’t have a financial office. That was quite a gap.”

She sees it as one of her greatest achievements; that there is now a well-established and well-functioning financial office, that also oversees risk management, and is integrated with the actuarial office and investment office.

“It took a few years to do that, and we needed to get regulatory approval. But that strengthened our financial and fiscal policies, and CAPR and treasury management were all strengthened,” she says. “This was a big shift and we are a leader in the US on our asset liability program, and the CFO and that office organises that. The financial office, actuarial office and investment office are all integrated, whereas before they were separate; so now the thinking is integrated giving us a holistic view of assets and liabilities.”

The benefits of size – 100 managers by 2020

During the seven years of Stausboll’s leadership, the CalPERS portfolio has grown from $181 billion at the end of June 2009 – a year where the market value of assets declined by 24.8 per cent – to more than $300 billion today.

Only a month after Stausboll was appointed as CEO, Joseph Dear* was appointed chief investment officer. The two became a formidable team focusing the portfolio clearly on the long term and what it means to be a long-horizon investor. This focus, as well as an emphasis on risk management, steered the portfolio out of the crisis.

Both Stausboll and Dear also had many years of experience working in large governmental bodies, with Stausboll holding various roles within CalPERS before becoming CEO, including serving as deputy general counsel, chief operating investment officer and interim chief investment officer, and previously chief deputy to the California State Treasurer. Dear also had many years of experience in governmental bodies, including executive director of Washington State Investment Board and assistant secretary of the US Labor Department, where he led the occupational safety and health administration.

This experience translated to a well-functioning organisation, almost despite its enormous lay board, as both Dear and Stausboll could communicate complex investment and business decisions in an effective way.

In addition to focusing on the long-term, the investment office has been focused on negotiating fees with external managers, and there has been a continued focus on costs.

“There are challenges of having a large portfolio, but there are advantages through being cost effective,” Stausboll says. “Reducing management fees goes to streamlining the portfolio, and we have a priority to make the portfolio less complicated.”

The fund’s decision to exit hedge funds in September 2014 is one example of that, and Stausboll says the focus is now on reducing the number of external managers in private equity and real estate, but also in equities. It is also decreasing the number of consultants and advisers it uses.

“We had more than 300 managers, and now we are down to 159. Our target is 100 by 2020,” she says. “That restructure has resulted in the past five years of a saving of $135 million not including profit sharing fees. We are a public organisation and want to use in-house as much as possible.”

While Stausboll admits that recruitment is difficult – with “internal staff pay an ongoing conversation” – once staff join CalPERS, “they enjoy it because of the strong mission and culture”.

Committed to sustainability

At the cornerstone of that mission, now, is sustainability. And Stausboll has been a driving force behind that. She is deeply committed to sustainable investment, and serves as chair of the Ceres board, the US’s largest coalition of investors, environmental groups, and non-profit organisations advocating for sustainable business practices.

She will continue on the Ceres board when she retires from her role at CalPERS at the end of June.

Stausboll is also a member of the advisory council for the United Nations Environment Programme (UNEP) Financial Initiative, which supports the regulatory and associated market innovations needed to align the financial system with the long-term success, resilience, and sustainability of the real economy. And she was a member of the working group that drafted the United Nations Principles for Responsible Investment and she served on the UNPRI governing board from 2006 through 2009.

Three years ago, the CalPERS board embarked on a project to deliver its first ever investment beliefs, and sustainability was at the core of that process.

“I’m very pleased with the development and clarity the investment beliefs brought, they are an anchor for the fund. The process to arrive at that was almost as important as the beliefs, because it helped relieve some tensions. It gave us clarity around ESG and integration,” Stausboll says.

“One of the exciting things that has happened in ESG is it is now not viewed separately from risk and return. But barriers remain, there is a lack of data around ESG issues, and we need reporting standards.”

Stausboll, and CalPERS, is supportive of the Sustainability Accounting Standards Board (SASB), which was formed to set market standards for disclosure of material sustainability information to investors.

“We think it is important that we get mandatory disclosure of ESG factors,” Stausboll says.

Last year CalPERS made the bold move of requiring all its managers to identify and articulate ESG in their investment processes.

Another barrier to ESG progress, she says, is the short-term nature of the industry, and in particular the short-term incentives in the industry, including in remuneration.

“It is important to include sustainability factors in compensation and incentive measures, and encourage managers and asset owners to look at their own compensation and set it in terms of the long term. That is hard to do. And three to five years is not necessarily long term when we are thinking about long term sustainability issues,” she says.

She urges asset owners and other organisations to partner on critical issues, with shared ideology, to leverage resources and impact.

“We are in collaboration, but investors aren’t necessarily natural collaborators. It is important to keep building this. The current proxy season momentum on issues is because of the collaboration,” she says.

Stausboll is the eighth CEO of CalPERS, and the first woman to head the pension fund.

“Women[‘s] representation in the financial industry is low, and gets lower the further [you go] up the ranks. But what I think is exciting is the heightened awareness around the positive difference gender diversity, and other diversity can make. This is a positive time for women,” she says.

 

*Joe Dear died in 2014 at the age of 62.

conexust1f.flywheelstaging.com remembers him, and the contributions he made to the industry.

James Grossman, chief investment officer of the $50 billion Pennsylvania Public School Employees Retirement System, PSERS believes disintermediation offers the most important opportunity for investors in coming years.

This global trend towards the reduced role of banks as middlemen, is an opportunity for pension funds to move into high yield corporate debt, he says, insisting that institutional investors are perfectly capable of directly lending to businesses to fill the gap left by banks.

“Pension funds can work with partners who understand how to underwrite credit and who have close relationships with corporate treasurers and know the companies well. In addition there will be no bank infrastructure costs eating away at returns,” he says, in reference to the securitisation process whereby banks’ corporate loans are repacked for institutional investors into lower yielding investments, reducing returns.

It’s just the kind of alternative opportunity that Grossman favours.

PSERS’ 60.6 per cent total funded ratio, as of June 2015, heavily informs investment strategy and his pre-eminence at the fund where he says “he has been around for a while” since joining as a compliance and risk officer in 1997, and becoming chief investment officer in 2014, has engendered many of the changes.

Volatility and risk have been steadily phased out with the reduction of the equity allocation to today’s 37.5 per cent target. While diversification has come with a range of strategies including a 20 per cent target allocation to fixed income, a 21 per cent target for real assets and a 10 per cent target for absolute returns – one portfolio, along with real estate and non-US equities, that did well in 2015.

It prompts Grossman into a robust defence of PSERS’ hedge fund allocation, up 4 per cent for the year, “right on target net of fees,” at a time when hedge fund performance and fees are under increasing fire.

“There is a misunderstanding of what hedge funds should or shouldn’t be doing in a portfolio: they aren’t meant to beat the equity market. If you’d like equity returns, hire a low cost equity manager. For us, hedge funds are a diversifying asset class with low beta and low correlation to equity markets, so that if equity markets fall, hedge funds are expected to do better.”

Casting a look back over PSERS’ 20 worst ever months in the equity market since 2005, hedge funds outperformed every time, with positive returns in 12 of those 20 months.

A new approach

New strategies will include PSERS increasing its allocation to diversified infrastructure from today’s one per cent allocation.

This will entail a more active, view spotting strategy focused on infrastructure within the private debt and private equity markets, rather than simply indexing global public market infrastructure equities.

“We believe the asset class has attractive characteristics and that it is less sensitive to economic cycles. There is lots of competition in infrastructure today but then there is competition for all assets with yield at the moment.”

Of the total fund, 22 per cent is in passive mandates. The 9 per cent allocation to US public equity is entirely indexed and 50 per cent of the non-US equity allocation is also in passive strategies; 80 per cent of the commodity allocation is passive.

Grossman does believe that there are opportunities to add value in non US small cap and emerging market equities where there is “less information flow,” and that active management also pays in fixed income.

Approximately one third of the portfolio is managed in-house with the rest with external managers.

“We don’t have the core competency or staff for private equity or direct real estate,” he says. Allocations to private credit and high yield are also outsourced.

“I believe there would be a cost benefit for the fund in bringing in more staff, but this decision lies with the Commonwealth,” he says, in reference to the State of Pennsylvania.

The decisions Grossman can control are manager selection and here he has persistently trimmed away. PSERS has terminated 19 managers over the past two years (101 mandates have gone over the past 10 years).

Other recent changes include bringing US equities in-house, and investment expenses fell over 18 per cent between 2014 and 2015.

“We are very aggressive when it comes to negotiating our fees, although in certain markets, namely private real estate and private equity, negotiation can be more difficult because of the increased capital going into these spaces. We maintain close relationships with all our managers, all the time. We certainly don’t give them $100 million and say we’ll see you in five years’ time. We meet and get to know them, sit on all of their advisory boards, and we are quick to spot any strategy drift.”

Tougher times for hedge funds means that negotiating fees with hedge fund managers has become easier, he says.

PSERS is also cutting costs by pursuing a co-investment strategy, begun in 2011.

Challenges include successful co-investment being dependent on the deal flow from managers – and managers having an excess deal flow they are prepared to co-invest out. It also requires a strong internal team able to do the due diligence and at PSERS Grossman has to rely on his existing staff to manage co-investments although he says he says he is “working hard” to illustrate the benefits of more staff in this area.

Co-investment, without any management fee or carried interest attached, layered alongside a standardised two and 20 private equity investment can effectively slash costs, he says.

“It can drive the all-in private equity and private real estate management fee and carried interest down, which amounts to co-investment being a considerable fee-saving vehicle, while at the same time enhancing net of fee returns.”

In 2010 PSERS had to sell 8 per cent of its assets to meet its pension obligations. Since then the fund’s negative cash flow has improved and reforms under the so-called Act 120 are gradually increasing the employer contributions to actuarially required levels. It makes for a stressful job but Grossman still enjoys it.

“We have a great staff and a good board of trustees who are supportive and open to ideas. I like mixing with some of the smartest people in finance and I’m definitely not doing the same thing every day.”

As new historical databases are opening up, there are great opportunities for out-of-sample tests of market anomalies. Research shows that the volatility effect also existed in the 19th century. Read more »

In discussing the fees paid by asset owners to investment managers, ‘alignment of interests’ is the objective most commonly stated.

But, in practice, almost all fees are structured either on the basis of a percentage of assets (such as 0.50 per cent), or a performance-related basis (with a base fee of for example 0.25 per cent of assets and a share of outperformance of say 20 per cent above a benchmark or target level).

But are there other ways in which fees could be structured which might, just possibly, be of benefit to both parties, which would surely represent an improvement in the alignment of interests?

Asset-based fees have obvious flaws.

They incentivise managers to grow their asset base by the greatest amount in order to maximise fee revenues (this is not a criticism of the behaviour of managers, it is just a logical view of the effect of these fee structures).

Growth in assets ultimately creates diseconomies of scale and the potential for reduced added value (‘alpha’) delivered by the manager.

Asset-based fees, particularly in volatile asset classes such as equities, also create volatility in levels of fee income for the manager and fees paid by the investor.

For some investors, this volatility can be a material issue, for example when fees are paid by a parent organisation or where fees have to be publicly reported.

For asset managers, it makes their business difficult to manage because their costs are predominantly fixed yet their income is highly variable for reasons outside their control or ability to forecast.

The problem could be addressed by having a fee structure which is a fixed monetary amount which could at outset be based on percentage of assets under management with agreed annual uplifts (for example based on inflation).

This would give both the asset owner and the asset manager a high degree of predictability as to the level of fees on a year-on-year basis, and, for the asset manager, there might be a willingness to accept a slightly lower level of fees than otherwise, because the predictability of this particular stream of income would give it additional value in terms of business planning, budgeting for expenditure and so on.

Performance-related fees are the conventional way in which alignment of the interests of asset owners and fund managers is meant to be achieved.  But as generally structured (base plus share of performance over benchmark) they are not without flaws.

First, to avoid the issue of asset growth leading to diseconomies of scale, performance fees should generally be combined with strict capacity limits for a strategy.

If the manager’s capacity is fully used up, then ‘success’ for the manager will solely be a function of performance through the mechanism of performance-related fees.

But what asset owners are happiest to pay for is not just ‘raw’ performance against benchmark, they want to pay for the added value created by manager skill.

And these are not necessarily the same: it is possible to generate outperformance of benchmarks by taking additional risk, such as by owning credit in a government bond-benchmarked mandate.  Leverage is another risk that can be used to enhance (or rather amplify) returns.

Managers can also adopt persistent ‘beta’ positions (i.e. overweights to an equity factor such as small cap) which may be more effectively captured via an explicit small cap mandate.

If one thinks about private equity mandates, these usually have a performance-related fee element in terms of ‘carry’ above a specified hurdle rate, say 8 per cent p.a.

At its simplest, returns from private equity can be thought of as having (potentially) three elements – a return from investing in equity-type assets, the leverage that is generally used in private equity investing, and the skill that managers use to create value in the businesses they buy and own for a period of time (we ignore for the purpose of this discussion other factors, such as value or size, that may also be driving returns in private equity).

This ‘idiosyncratic’ alpha, value creation by managers, is a really attractive source of return – it is probably fairly scarce and certainly diversifying relative to other sources of return.

Unfortunately, the ‘carry’ approach over a fixed hurdle rate is a very crude way of rewarding a manager for the skill they employ because the total level of return generated in a private equity fund will be heavily influenced by the performance of equity markets during the period of capital being invested ‘in the ground’, exacerbated by leverage, and skill applied will only be a third element on top of these two.

So 8 per cent p.a. will be too low a hurdle if equity markets are buoyant (managers who have demonstrated no skill will collect big performance fees) while it will be too high a hurdle in a period of weak equity markets and really skilful managers may not earn performance fees.

The way to address this is not simple, but it would be for the asset owner and fund manager to agree on a way of isolating the ‘idiosyncratic’ alpha that the manager has generated, and rewarding this well, because it is valuable.

This process might involve (in the private equity example) stripping out what returns the asset owner would have seen if the same capital had been deployed in listed equity markets at the same time (and adjusting for the effect of leverage and other persistent factor exposures).

If this could be done with a reasonable degree of accuracy and robustness, then the manager would be confident in his skill being rewarded (regardless of the market environment) and the asset owner would be confident that performance fees were being paid for genuine added value, not market returns or leverage.  Both sides ought to be happy with this approach.

In what many are describing as a ‘low return world’ investors will quite rationally seek to control fees and other costs. We believe that it is in the asset management industry’s own self-interest to think creatively and engage proactively with asset owners in order to achieve a better alignment of interest in fee structures.

 

Nick Sykes is the director of manager research at Mercer.

“It looks like a beautiful day!” greets Vijoy Chattergy, chief investment officer of the $14.1 billion Employees’ Retirement System of the State of Hawaii, HIERS, speaking from his office in Honolulu. Chattergy is in the final stages of constructing a new risk-based asset allocation at the fund.

It’s the culmination of a process of reform and regeneration to build a more robust portfolio that began after the GFC, and hastened by the alarming increase in the fund’s unfunded liabilities.

“If you go back 15 years, HIERS had a strong funding status but it has deteriorated to where we are today at 62 per cent. We realised that what we were doing was not going to take us forward. It was a bit of a wake-up call,” he recalls.

Chattergy has led the overhaul at the fund since he was appointed chief investment officer in 2012, having initially joined as an investment specialist. Previous roles included working for the Federal Reserve Bank of New York, and recommending investments in a fund of hedge funds for Japanese asset manager SPARX Group in Tokyo and Hong Kong.

Returning to live and work in Hawaii after two decades away was always his dream, but the challenge of getting the state’s largest pension fund back in the black is the day-to-day reality.

“Lots of my family and friends are members of the plan,” he says. “Mum and Dad are retired professors. My brother is a public sector teacher. If the fund has a bad quarter we have a difficult Sunday dinner!” he says, only half joking.

The new risk-based asset allocation divides the portfolio into a 76 per cent allocation to broad growth, 12 per cent to principle protection, 5 per cent to real return and a 7 per cent allocation to real estate.

Broad growth includes US and global equity, private equity – targeting 10 per cent of the broad growth bucket – and covered calls, first introduced as an asset class in 2011; a less volatile equity exposure comes through credit strategies.

Although broad growth currently accounts for three quarters of the portfolio, this will fall to 63 per cent by 2020.

“We are actually re-making the equity portfolio under new policy guidelines. We’ve completed the passive manager, options-based equity manager, and low volatility global equity selections; and are now finalizing a global equity large/mid-cap and small-cap searches.” The real return portfolio comprises inflation-hedging allocations to timber, agriculture, infrastructure and TIPS.

Crisis Risk Offset allocation

As the outright allocation to long-only equity managers falls, the slack will in part be taken up by a new Crisis Risk Offset (CRO) allocation expected to rise from 10 per cent at the end of 2016, to 20 per cent of the portfolio by 2020.

Here the allocation will be split between tilts to systemic trend-following strategies, alternative risk premia and long duration treasury bonds.

It’s a strategy especially designed to counter equity risk, resulting in a more stable return pattern for the overall portfolio over time. Its crisis-period focus means returns from the allocation may be challenged during non-crisis periods, but Chattergy is convinced of the benefits.

“The CRO is designed to be a line of defence in a major market crisis and should absorb prolonged shocks,” he says. “Success may hinge on our ability to maintain a disciplined approach. When equity markets go up in a bull market we do not want to abandon these principles, as we lag our peers and market indexes. If you believe that periodically there will be crisis events, this approach can work through a full cycle. This is the way we now see the world.” Chattergy plans to go to the market in early summer with a Crisis Risk Offset search. “We need managers that are experienced and knowledgeable for the allocation.”

The readjustments and turnover in the portfolio has resulted in a bidding process that is allowing HIERS to renegotiate better fees with its managers.

“We are substantially bringing down our costs,” he says. HIERS, which has grown under Chattergy’s leadership to have five investment professionals, has “no desire” to build the infrastructure for “an investment shop” at this time.

However, the fund may build an in house capability to better participate in private market investments.

“We will seek opportunities in the private market where we can outperform public markets,” he says.

A bigger in-house team would potentially allow the fund to be more responsive to co-investment opportunities and one off projects.

Chattergy hopes to have increased assets under management to around $20 billion by 2020. Long-term his aim is that the fund is fully funded by the mid-2040s, estimating that by then HEIRS will have $45 billion assets under management.