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Editor’s Letter: Taking a stand on fees comes with selection risk

I recently was sitting over coffee with an investment-relations professional, and the topic of Réal Desrochers came up. I was wondering whether my source had heard anything about Réal retiring.

My source hadn’t heard anything but went on to talk about how the firm wasn’t going to invite California Public Employees’ Retirement System into its new fund. CalPERS had become tough to deal with — what with all the pushback on fees and the burdensome reporting requirements the system had put in place for its GPs. It wasn’t worth it, my source said.

This tougher stance on fees was a hallmark of Desrochers’s leadership as head of private equity at the nation’s largest pension system. After extensive internal investigations into the costs of PE, the use of placement agents and a pay-to-play scandal, the system had reached a point where it demanded extensive reporting from its managers, and fee breaks in exchange for its pension dollars.

Nowadays, CalPERS is cutting its portfolio from about 100 relationships to about 30 over several years. Those 30 core managers will be blessed with big checks from CalPERS.

CalPERS has gradually whittled down its portfolio through secondary sales. The system, like many large institutional investors these days, likely believes it can get more value from PE by targeting specific relationships with strong performing GPs that can offer multiple strategies. CalPERS, because of its outsized influence, can negotiate friendly terms not available to smaller LPs.

But as the IR professional made clear, GPs over the years have decided to skip a visit to CalPERS, which 10 or 15 years ago would have seemed an irresponsible move for a fundraising GP. It has become apparent that because of CalPERS’s tough stance on fees (a good stance to have), the system may have missed out on some great PE opportunities.

This is especially true these days with large sovereign pools of capital prepared to cut big checks and not push back too much on fees. These sovereign pools are more interested in partnering with GPs to get a slice of their direct deal activity rather than pairing with managers solely for LP stakes.

Sources often talk about situations where an institution is so tough on fees that it alienates the best-performing funds and leaves itself only mediocre managers who are willing to give fee breaks because they need the money.

This is anecdotal, but the IR professional I talked with confirmed that at least for one firm, this was the case.

It’s a curious dilemma. This industry absolutely needs powerful LPs to push back on terms and conditions, especially in hot fundraising markets like today’s, in which GPs can dictate terms. However, those big institutions risk losing out on the best GPs who, because of the nature of the bull market, can pick and choose their partners.

Maybe it all changes when the market crashes, LPs pull back and GPs get a little more desperate for capital. Until then, institutions that take hard stands like CalPERS might be stuck looking from the outside in at the top-performing firms in the market.

Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky