Private Equity: Fees Falling but Future is Bright

Over the past several years, valuations have gone through the roof, which is good if you’re selling a business, but will inevitably hurt private equity firms deploying capital (unless valuations remain at these high levels for several more years). At the same time, LPs are becoming more concerned with the fees being charged by GPs. Funds that have not performed in the top quartile are likely going to be faced with either raising a smaller fund or reducing their fees (many are shifting toward 1.5/15 model). If GPs are really struggling to raise money, they may need to both cut fees and raise a smaller round.

How did this happen?

There are several reasons for the push toward lower fees. One reason is the performance of the stock market. Since 2013, the Dow has gained nearly 60%, making exposure to the public markets look more attractive and potentially less expensive. Additionally, public markets provide the liquidity that private equity funds cannot; typically, LP’s funds are locked up for 10 years in a private equity fund.

So why is private equity’s future so bright?

Well, unlike picking stocks, private equity’s long term future is not under threat from algorithmic trading. It is not hard to imagine a future in which hedge funds and stock pickers are only able to differentiate based on the algorithms they use. Even then, over time technological parity will compress returns and the overall market for these alternative investment vehicles will shrink. Since private equity relies on many intangible aspects to evaluate investments, the industry will be much more insulated from pure technological methods.

For example, meeting with management teams and discussing a company’s future or specific market trends can tell you a lot about a company’s prospects. Similarly, walking a manufacturing floor, you might be able to identify inefficient production methods which could be quickly changed to boost productivity (something you can’t find on a spreadsheet). Another component could be pursuing a rollup strategy in a fragmented market where execution risk would beset lesser operators. These examples highlight some of the limitations of technology within private equity investing. Thus, there will be less long term parity in the industry which will ultimately benefit better investors/operators.
While the private equity industry has come under pressure recently from LPs to reduce fees, the long-term prospects remain strong. It is an industry where the best investors long term, not the best technology, will win the day.

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