The old model for private equity bonuses is broken and we need to find a new model argues Mike Fell, in a recent guest post online for The Financial Times.
Fell, a partner at independent private equity firm, Key Capital Partners, in the UK, feels that the traditional compensation model of the past 20-30 years has contributed, in part, to the negative reputation of private equity managers as corporate raiders, asset strippers, “fat cats” and overall barbarians at the gate.
The reason? The standard private equity model came into effect when the average PE fund size was roughly around 20 million pounds in size (US$32.9 million). At the time, private equity was seen as an attractive alternative asset class, one that has indeed delivered a 13.1 percent average rate of return over the past 10 years. Private equity’s success attracted more capital to the industry. But soon, managers grew fat on their two percent management fee, and less focused on the 20 percent performance fee (also known as “carried interest”). Funds became asset collectors. The larger the fund, the less incentive to achieve oversized capital gains.
The recent financial crisis put an end to this trend. The current lack of liquidity in the industry, and reduced allocations to private equity, have by now encouraged pension funds and other major investors to seek a closer alignment of their interests with those of the private equity managers, says Fell.
In his opinion, management fees should only cover the reasonable costs associated with administering a fund. The real reward should be in the carried interest portion, which is directly tied to performance. He also thinks investors should not be locked into poor-performing private equity funds. In other words, they should have the ability to yank their money out of the fund without penalty.
Heresy? Fell doesn’t give any examples of PE funds following his new paradigm. Although one presumes that his own firm, Key Capital Partners, follows this philosophy. He does admit though, that “unless the pension fund industry is prepared to act in unison, wholesale change to the current private equity structure will remain difficult.”
What’s your opinion? In light of recent market turbulence, do you think private equity managers will be adjusting their compensation structures to be more flexible and open? Add your comments below.
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