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E-MailJuliane Begenau is an Associate Professor of Finance at Stanford Graduate School of Business, and Emil Siriwardane is an Associate Professor of Business Administration at Harvard Business School. This post is based on their recent article forthcoming in the Journal of Finance.
The private capital industry has experienced a meteoric rise over the past two decades, with estimates of capital invested in vehicles like private equity and venture capital now exceeding $10 trillion. With this growth, there has been a corresponding increase in calls for greater transparency around the fees and operational structures of private market funds, especially given the amount of capital inflows from public defined-benefit pensions around the globe. Private capital funds, like private equity, are typically governed by complex limited partnership agreements (LPAs). LPAs, which are rarely observable to fund outsiders, are often further modified by so-called side letter agreements. This contracting environment makes it difficult to answer basic questions about costs in this industry, like for instance whether fees are set uniformly within funds or if some investors (LPs) consistently pay lower fees.
Our research published in the Journal of Finance makes progress on these questions by taking advantage of a simple fact: if investors in the same fund pay different fees, they should earn different net-of-fee returns. This observation allows us to characterize fee policies within and across funds without observing the LPAs and side letters. An added benefit of our approach is that it puts fee differences into terms that ultimately matter for investors, namely returns. Using a sample of 2,400 funds raised between 1990 and 2019, we establish several new facts about costs in private capital funds.
Dissecting Fee Variation
First, most funds operate with a two-tiered fee structure. There are of course many different types of fees that could vary across fee-tiers in the same fund, including management fees, incentive fees (or carried interest), organizational fees, or portfolio company fees. We focus on how much the first two categories vary across fee-tiers in the average fund. Our estimates suggest that management fees and carry vary across fee-tiers in the same fund by about 91 basis points and 5.8% on average. These estimates of within-fund fee differences also differ substantially across asset classes and are much lower in venture capital funds.
Second, we study the key factors that drive differences in fee policy across funds. Some GPs consistently use the same contract structure across all the funds they manage. For example, venture capital funds are far more likely to use a single fee tier for their investors, implemented through a standardized and uniform LPA, compared to other types of funds. Moreover, the legal industry also appears to play a large role in fee policy, as law firm identity is a strong predictor of which funds use multiple fee structures. Fee policy also depends on the fund-raising environment. GPs that are in high demand, like those with high past returns, are less likely to use complex fee structures. This result likely reflects the fact that high-demand GPs can fill their funds without needing to offer additional fee concessions to investors.
Third, we document that some LPs consistently pay relatively lower fees across all of their funds. Some of this effect is explained by investor size and sophistication. However, even after controlling for observable differences between LPs, some continue to pay lower fees than others. This result suggests that factors like negotiating skill and personal relationships with GPs meaningfully influence the fees that LPs pay in private capital funds.
Implications for Investors and Regulators
Our findings indicate that investor sophistication and negotiation skill are crucial in determining fees, and hence, performance within this asset class. Consequently, streamlining the process through which LPAs are negotiated is likely to yield large benefits for LPs, especially those not endowed with large investment teams or extensive experience in private capital markets. In this regard, recent initiatives by trade organizations such as the Institutional Limited Partners Association (ILPA) to standardize LPAs and fee reporting are, in our view, productive steps forward.
Regulators might also take note of our findings to consider ways to enhance disclosure and transparency in private equity investing, ensuring that all investors can make informed decisions based on a clear understanding of the fee structures and their potential impacts on returns. Several elements of the Securities and Exchange Commission’s (SEC’s) new private funds rules around fee transparency and fund disclosure appear aligned with this goal.
