Private equity firms offer sweeteners to lure reluctant investors

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Private equity firms are increasingly offering sweeteners such as fee discounts to secure backing from deep-pocketed investors, in a sign that the industry is facing its toughest-ever fundraising environment.

Blue-chip firms including CVC Capital Partners, Ardian, TPG and Cinven have all in recent months offered investors either a discount on management fees or other incentives such as larger amounts of so-called co-investment, which enables investors to get a bigger slice of individual deals without paying a fee, according to people familiar with the matter and fund marketing documents. 

Some firms are even offering big backers such as pension plans and sovereign wealth funds a slice of the management fee that usually goes to the fund manager. 

“Almost every firm in our suite of clients is contemplating or has employed some form of incentive for investors to put capital in as quickly as possible and in as large a size as possible,” said Sunaina Sinha, head of private capital at Raymond James. 

The favourable terms being offered to potential backers are a function of an increasingly competitive fundraising market. After years of dashing headlong into private equity, many big investors have been unwilling — or unable — to allocate fresh funds to the asset class because a drought in dealmaking and public market listings makes it tricky to exit existing investments.

In the first half of 2023, firms globally raised $517bn, a 35 per cent fall against the same period a year ago, according to a Bain & Co report released in July. The report found that for every $3 of capital firms are trying to raise, investors only have $1 available to allocate to private equity, the worst imbalance since the global financial crisis. 

The tough fundraising market has seen the pendulum “undoubtedly swinging” towards investors, said Karl Adam, a partner at advisory firm Monument Group. That has enabled them to push for better terms than they would typically secure.

The efforts are largely focused on private equity’s biggest backers like pension plans and sovereign wealth funds who are being offered the chance to cut the overall fees they have to pay to get access to some of the industry’s top-performing funds. 

“You don’t normally get much by way of special deals,” said the head of investor relations at one European private equity firm. “But they typically get linked to size.” 

Ardian, which this year has raised more than $20bn for its flagship secondaries fund, received a $6bn cheque from the Abu Dhabi Investment Authority; this included $4bn to go into the fund and $2bn for co-investment, according to a person familiar with the matter.

Cinven recently hit its €12bn target, boosted by offering new, large investors co-investment, according to people familiar with the matter. The firm is also continuing to raise more money, the people said. 

Ardian and Cinven both declined to comment.

Other tactics firms are using include giving a discount to their largest investors and offering so-called management fee holidays.

For example, CVC offered large investors a management fee discount on its recently closed record-breaking €26bn flagship fund, according to a fund marketing document.

Some investors were able to pay a management fee of 1.375 per cent, less than the 1.5 per cent charged to other investors. To be sure, CVC has previously offered larger investors in previous funds a fee discount although industry insiders say this practice is becoming more common, particularly at funds that are less in demand than CVC.

For investors in the asset class, securing co-investment or fee discounts can help boost overall returns, net of fees, at a time of concern over the impact of rising interest rates on private equity’s ability to outperform cheaper options such as investing in stocks or bonds. Private equity fees are among the highest in the financial services industry. 

Typically, firms charge a 2 per cent management fee and 20 per cent of profits above a performance hurdle.

“It’s going to be harder [for private equity] to produce those returns because you don’t have cheap leverage,” Jon Little, the incoming chair of Local Pensions Partnership Investments, which manages £24bn of local authority pension cash, said. He added the industry’s fee model was “hard to justify”.

The California State Teachers’ Retirement System and California Public Employees’ Retirement System — two of the largest US public sector pension funds — said last month their private equity portfolios delivered negative returns in the most recent financial year, even as public markets surged.

Calpers said its primary initiative to reduce costs was increasing co-investment, without management fees and carry, “alongside our partners in high-conviction opportunities”. The fund added that it expected private equity to outperform public equity markets over a five-year period, and that it remained “committed” to the asset class.

Some private equity firms are having to get even more creative.

To boost the size of a secondaries fund launched last year, US private equity giant TPG struck an unusual deal that gave Canadian pension fund Alberta Investment Management Corporation a share in the fund’s management fee stream in return for a commitment to invest.

Despite the concessions from the private equity industry, investors hoping for an end to the two-and-twenty model are likely to be left disappointed. The current rash of inducements is a way of protecting a fee system that has changed little over the past few decades, according to Gabrielle Joseph, a partner at advisory firm Rede Partners.

“There isn’t so much overt discounting but there is secret discounting” such as fee-free co-investment, Joseph said. “What we haven’t seen is a lot of change in the overall headline fees.”