23 Oct Private Equity and Hedge Fund Two and Twenty Deal Structure is Dying
I was recently reading one of Warren Buffett’s annual shareholder letters, which are always insightful as well as entertaining. In it, he describes the typical AUM fees charged by fund managers which could include private equity funds, hedge funds and venture capitalists:
In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is –on an expectancy basis – clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.
Much of the financial damage befell pension funds for public employees. Many of these funds are woefully underfunded, in part because they have suffered a double whammy: poor investment performance accompanied by huge fees. The resulting shortfalls in their assets will for decades have to be made up by local taxpayers.
Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”
Long ago, a brother-in-law of mine, Homer Rogers, was a commission agent working in the Omaha stockyards. I asked him how he induced a farmer or rancher to hire him to handle the sale of their hogs or cattle to the buyers from the big four packers (Swift, Cudahy, Wilson and Armour). After all, hogs were hogs and the buyers were experts who knew to the penny how much any animal was worth. How then, I asked Homer, could any sales agent get a better result than any other?
Homer gave me a pitying look and said: “Warren, it’s not how you sell ‘em, it’s how you tell ‘em.” What worked in the stockyards continues to work in Wall Street.
The insight could be applied to many more unrelated areas. In short, the reason institutional investors pay such high fees for money management is due in part to at least one of the following:
1. It has become typical practice among asset managers.
2. Investors expect to receive premium advice by paying premium fees.
3. It is all about how it is sold.
In today’s world “typical” practices or processes are being disrupted in nearly every sector and marginal advice is unfortunately not correlated with marginal cost. According to Mr. Buffett, “Very wealthy investors are accustomed to superior service and products in other areas of life, and they mistakenly think superior products and services are also available in financial services…They end up wasting trillions of dollars on overly complex and ineffectual hedge fund strategies.”
I am keenly aware of at least two smaller private equity fund managers with different approaches who have performed much better than average. For instance, both groups take 0% as their management fee. However, they participate in a more equal split upon the exit from a deal. Instead of charging investors more fees for managing the fund, they have built a model that is more of a “buy-in,” giving themselves much more of the upside by taking the ride with investors. Confident and experienced managers, both groups are looking at very large exits within their portfolios this year. Because they acted like partners with their client’s money, they are taking much more on the success of the deal, rather than the luxury and security of annual management fees.
It reminds me of how Arnold Schwarzenegger took a ride on the movie Twins. Partner skin in a deal is a direction some smaller groups are going. I would expect that paradigm to continue to shift as overall asset management fees shrink thanks to things like roboadvising, digitization and overall disintermediation.