Those well-versed in private equity know to consider the so-called “2 and 20” fee model, made popular during the heydays of hedge funds, as par for course. But two industry veterans consider it as a broken model — and have set about fixing it with a new fund.
The long-term private capital (LTPC) offering from BlackRock, which aims to ultimately raise US$10 billion to US$12 billion, was engineered specifically to “create a better alignment of interests than in traditional private equity,” reported Institutional Investor. Specifically, the fund has the ability to hold companies for “up to forever” in multibillion dollar deals — considered by BlackRock as less risky — which relieves the pressure to sell companies and opens up the possibility of lower fees.
Early sketches of the idea came from Mark Wiseman, chairman of BlackRock’s alternative-investment unit and global head of active equities, in late 2017. He has reportedly been working on it with André Bourbonnais, who now heads BlackRock’s LTPC team, for the past year.
The concept germinated from frustrations with what they viewed as an outdated leveraged-buyout model. As colleagues at the Canada Pension Plan Investment Board (CPPIB), they were constantly aggravated at having to pay 2% of assets for private-equity funds — something that made sense when young funds were truer to their purpose of covering the costs of operating a buyout firm, Wiseman said. Now when firms are profiting handsomely from significant decades-long growth across multiple funds, there’s not as much justification.
“It’s nonsensical,” Wiseman said to Institutional Investor. “The funds got larger, larger, and larger, but the cost of running the firms didn’t grow proportionally.”
As he explained, managers would begin raising a third investment pool even as they had the first and second funds already running. The upshot is that they’d collect three times the cost of managing the firm. While running a US$10-billion fund costs more than doing so for a US$500-million one, Wiseman said, but economies of scale mean it doesn’t cost 20 times more.
Considering the massive fees collected and the proportionately lower costs, Wiseman believes reducing fees from 2% to 1.5% — as BlackRock has done with LTPC — is a more-than-reasonable concession. He also takes the view that a large asset manager should bear the burden of accurately projecting the costs of running LTPC — as well as the risk of eating the portion of costs that they fail to anticipate.
That’s exactly what BlackRock’s LTPC fund aims to do. Clients will be presented with a transparent budget to approve every year. Any cost over the budget counts toward BlackRock’s ledger; in case expenses fall under budget, investors still benefit as they pay an explicit percentage over the cost of managing it.
Also, the fund’s ability to hold firms for decades rather than the much shorter periods for other buyout funds, which are incentivized to “crystallize their carry” and post higher internal rates of return by exiting companies within a relatively short time. Constant selling of companies, Wiseman argues, results in “massive frictional costs” for investors.
“It’s terrible for a long-term investor,” he said. “If I have a good asset, I want to hold it forever.”
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