Private Markets: Fees and Value Creation¹

Outcomes are uncertain, and human nature craves predictability. That's why (amongst other reasons) we seek comfort in economic forecasts, market forecasts, etc. (2% inflation?). We like having a forecast as a navigational aid; it's comforting. In the context of private markets predictability can be elusive.

One exception is fees.

Fees are a variable an investor can control through choice, and presumably, negotiation. Achieving a fee reduction is a tangible victory—shaving 50 basis points off asset management fees boosts returns by an equivalent amount.

For those tracking market beta, every basis point counts, making this effort meaningful. Yet, when we examine private markets strategies with limited capacity and a niche appeal—the significance of those 50 basis points typically diminishes.

In certain categories, where demand far exceeds supply and opportunities are rarer (often offering the potential for outsized returns), an excessive focus on fees can be misguided.

“When you are considering an investment in a capacity-constrained opportunity with a specific exposure, the fee schedule is not going to have a material impact on the outcome. Focus on the opportunity and the ability of the investment partner to execute the strategy.”
- Michael Leffell • Founder & Chairman, 10 East

Remarkably, the performance differential between top and bottom deciles in private equity is a staggering 30.36% (net IRR, see illustration below).

Historical Private Equity Returns (1998-2023)²

Shift focus from fees to performance potential.

Larger-scale, blue-chip exposures (think mega funds) are likely to have much lower performance dispersion and cluster around the median. The markets that these players are in generally have much greater efficiency, more competition, a smaller investment universe, and often a higher correlation to market beta.

The opposite is typically true for niche, smaller-scale (sub-scale) exposures—higher performance dispersion, less efficiency, and much more 'low hanging fruit'—creating greater opportunity for excess return. That's not to necessarily imply that blue-chip exposures are inferior relative to sub-scale, it simply underscores different risk/return dynamics.

A well-balanced portfolio may benefit from both.

Theoretically, your expected return on private market exposures can be decomposed into a few key elements: i) market beta, ii) illiquidity premium, and iii) a value creation premium (VCP) (see illustration below).

Expected Return and the Value Creation Premium (Private Equity)

Source: Pitchbook, 2023.

What actually matters?

VCP.

Of these return drivers, the two controllable variables are i) fees and ii) identifying talented operators/partners who have the potential to create value.

The latter moves the needle, the former largely does not.

As such, negotiating 50 basis points off the GP's fee, for specialized exposures, can be somewhat of a fool's trap with downside asymmetry in the form of adverse selection and soured relationships, which, paradoxically contribute to the VCP.

Key drivers of the VCP:

• Specialization: having a depth of knowledge where others don't;

• Information Advantages: knowing what others don't;

• Adept Execution: creating structures and executing where others can't;

• Sourcing: seeing 'first look' deal flow;

• Access: gaining access to 'first look' deal flow, and/or proprietary networks;

• Selection: possessing time-tested filtering heuristics or due diligence processes;

• Network: ability to tap specialized knowledge or augment access.

What's the takeaway?

When the expected VCP might be relatively low, fee negotiations should be more of a focus. With blue-chip exposures, where there's typically less performance dispersion and greater market efficiency, the fee schedule can be material. But in categories with higher dispersion, and greater potential for a high VCP, fees are usually less material.

Investors should expend resources on proactive deal sourcing, due diligence, research, and network expansion. Forge and grow long-term partnerships with talented individuals and industry specialists. Create and contribute value, by being a thoughtful partner, not by extracting it.

Further, focus on minimizing exposure to adverse selection and fraud—two key risks likely to relegate investors to lower quartiles/deciles.

The allure of a lower fee schedule may be psychologically soothing but will generally not change the outcome of a lower quality fund manager or exposure to a sector with deteriorating fundamentals, leading to underperformance. Focus on what matters—identifying investments with the highest potential to outperform.

Don't win the battle to lose the war.