Study: Only top GPs worth their fees

Investors in some private equity funds may as well be putting their cash in a passive index fund, according to research soon to be published by Cyril Demaria of the University of Sankt-Gallen in Switzerland.

On a gross basis the average private equity fund outperforms public market indexes, but after accounting for management and performance fees, net returns to investors are in line with exchange traded funds, he found.

“Fees hence capture the alpha of GPs,” said in the study Demaria.

Top quartile GPs however generate returns higher than the public markets even net fees, the study found. The findings come at a time when some commentators and think tanks argue that investors should reject actively managed funds for passive index funds that charge less in fees. 

Using a public market equivalent (or PME) methodology, the study timed the cash-flows of private equity funds with the performance of inclusive public market benchmarks, for example the US Wilshire 5000 Total Market Index. 

To capture returns net of fees, the research assumed the industry standard ‘2-and-20’ model in management and performance fees, and assumed a lower standard fee rate for exchange traded funds that track public market indexes.

The study said fees do not “make or break” a fund’s performance compared to an exchange-traded fund. However the study also suggested top performing managers were worth the carry and management fees they charge, saying that “high fees do not have a negative impact on net performance”. 

Demaria attributes top GPs’ outperformance to having made investments earlier in the fund lifecycle, when large wins or losses can have a material impact on fund IRRs. “Changing the incentives of GPs to invest earlier, by calculating management fees on the capital invested, might hence increase the overall performance of a fund,” said Demaria in the study. 

The study is unique from similar private equity research as it recorded a fund's profit or loss on a pro-rata basis for each distribution. Other research would only record a profit after an investor’s full fund commitment was returned in distributions, which Demaria said during an interview can warp IRR measurements.

“Though this distribution mechanism does not reflect reality, it is methodologically more relevant than assuming first a refund of the full amount of the committed capital, and then a pure distribution of profits in the later years of the fund lifecycle.”

Demaria added his research may open a discussion on hurdle rates, which he believes may be too rigid. Adjusting the hurdle rate down when public markets are performing poorly, or up when stocks are strong, would better reward GPs’ capture of alpha. 

A hurdle rate pegged to public market performance would “avoid sanctioning GPs when the overall macro conditions are weak, and would maintain the incentives to perform consistently,” said Demaria.