GPs mine management fee gold on dry powder mountain

GPs are collecting $6 billion to $8 billion of management fees on the $400 billion of dry powder sitting in buyout funds. This is an extraordinary transfer of wealth from LPs to GPs — on money that is not being put to work.

That is what one limited partner told me when I asked about Bain & Co’s recent Global Private Equity Report 2014 that shows a $1 trillion mountain of uncalled capital across private investments. This includes $400 billion dedicated to buyouts (other strategies are venture, real estate, mezzanine, distressed, infrastructure and growth).

With about $400 billion of uncalled capital sitting in funds, limited partners are paying between $6 billion to $8 billion in management fees (assuming a 1.5 percent to 2 percent management fee).

“That’s a tremendous wealth transfer going on year in and year out as it relates to unfunded commitments,” the LP said. “It underscores how much capital is transferring from the LP community to the GP community.”

It’s not like this is a new thing — management fees have always been part of the industry, and LPs willingly sign up to pay those fees to have what they hope are the most talented managers making them money.

But still, “this is not for active investments in the ground, but for pools of capital that have yet to be funded,” the LP said. “At some level, there will always be a need for management fee streams to keep the operations of private equity funds continuing. On the flip side, these management fees continue to be a source of profit for a lot of GPs, particularly the larger ones.”

It’s an interesting perspective, and one I wasn’t expecting. I was expecting to hear the usual concern over what such a huge glut of capital means for the industry.
Or what it could mean, which is this huge glut will drive up prices and potentially depress the performance of whole vintage years. Add to this that commitments are on a deadline and have to be invested usually within five years of a fund closing — and the concern is that GPs will be under pressure to put money to work before time runs out.

But here’s the thing: We’ve heard these concerns before, and they haven’t really played out. Recent year vintage performance has remained steady despite the persistence of huge levels of dry powder year after year. According to the most recent Cambridge Associates performance data for the third quarter 2013, the U.S. private equity index returned 5.1 percent, and 13.3 percent for the year to date. That return is 17.2 percent over the one year, 15.7 percent over the three year and 11 percent over the five year time periods.

The concern really is on an individual manager level, rather than on an entire industry level. Some managers are going to raise too much money, make dumb decisions and lose their LPs money. But maybe that’s more about an LP’s ability to pick the right manager, and be vigilant when they think a GP is getting too ambitious.

Because LPs are not only trusting the GP to make them money, they are also paying them huge fees, usually on money that isn’t even in the ground yet. And that’s not something any investor ever forgets.

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