What Public Pensions Pay When They Chase Private Equity

Over the past decade, torrential inflows of capital into private markets have transformed private equity and other unlisted funds into a mainstream asset class. Private assets under management are expected to surpass $17 trillion by 2025, a 60% increase over 2020. This boom has been driven by defined-benefit public pension plans seeking higher returns than they can realize from bonds and stocks.

However, as more public money has flooded into private investments, calls on fund managers for greater fee transparency have grown. In February, the Securities and Exchange Commission proposed that private equity funds report standardized quarterly data on fees, expenses, and performance. That followed a scathing “risk alert,” in which the regulator found that some funds had been presenting misleading or inaccurate information about their performance — and overcharging investors.

Private equity fund managers typically charge “2 and 20” — a 2% annual management fee and a 20% performance fee if a benchmark is beaten. Investors may additionally pay hidden expenses such as consulting and legal costs accrued by portfolio companies. Investors have lashed out at these extra costs, including the PE managers’ use of private jets.

In a recent paper, Juliane Begenau, an associate professor of finance at Stanford Graduate School of Business, and Emil Siriwardane of Harvard Business School shed new light on the opaque fees within private equity and other private market funds. “The private capital industry is extremely secretive,” Begenau says. “Everything is bilaterally negotiated. But, as we teach in business schools, price transparency is correlated with well-functioning markets.”

Same Fund, Different Fees

They found that investors pay different fees within the same private market fund, which affects their returns. The estimated average divergence within a fund is 0.91% for management fees, and 5.8% for the performance fee, or carry.

There are also differences between asset classes. Private debt and real estate funds have the largest deviation in performance fees — 6.8% and 6.4%, respectively. The carry dispersion in venture capital funds is only 0.5%, reflecting the use of standardized contracts with investors.

Begenau says policymakers may consider requiring other private funds to standardize their contracts with pension plans, but she warns this could restrict their access to private markets. “If you impose the same fees, the downside might be that some funds pull back and say, ‘We don’t want to deal with public pensions.’”

Begenau uncovered the divergence in private market fund fees by studying the net return earned by two investors who entered the same fund simultaneously. Their returns were broadly similar for the first decade. But a wedge emerged after that, with one investor earning $1.62 per dollar invested, compared to $1.54 for the other, suggesting that they were charged different fees.

Using machine learning techniques, Begenau used these results to assess a large dataset covering $438 billion of investments made by more than 200 U.S. public pensions in 2,400 private funds. The results showed that most funds do not set fees uniformly, typically clustering investors into different fee tiers. In the sample, 36% of funds had one tier of fees, 61% had two, and the remainder had three or more.

In addition, Begenau found that the law firm employed by a private market fund is a key determinant of why some use multiple fee structures. “Some private equity funds associated with certain law firms tend to do this more versus others,” she says. “This points to a contract-based explanation.”

That also explains why venture capital funds are 33 percentage points less likely to tier investors than private equity, and 48 percentage points less likely than infrastructure funds to do this.

Further, the research found a negative relationship between investor demand and the use of multiple fee structures. Fund managers without an established track record are 13 percentage points more likely to tier investors. Undersubscribed funds are 12 percentage points more likely to use multiple fees.

In addition, private capital funds that use placement agents — who connect investors with funds — are more likely to tier fees. This is likely because agents take a cut of the money they bring in, and funds may pass on the cost to their investors. “It’s another way of skimming off some fees from pensions,” Begenau says, noting that some pensions are trying to cut costs by placing restrictions on the use of placement agents in private markets.

Lower Fees for Big Investors

Begenau points to signaling effects as one explanation for fee tiers. “If it takes a long time to close the fund, you may forgo profitable investment opportunities, so you’re more likely to offer fee breaks as a way to attract more capital commitments,” she says. She suspects fund managers are likely to slash fees for big cornerstone investors who would instill confidence in the fund. “You may cut a deal to get CalPERS on board,” she says, citing California’s public pension plan, the biggest in the U.S.

Because fund managers offer fee reductions to investors who can help lower the cost of raising a fund, some public pensions tend to pay relatively lower fees across all of their funds. Accordingly, the study finds the biggest pensions and those that contribute more money are likely to be in the lowest fee tier.

Another important factor is investor sophistication: Pensions in low-fee tiers tend to be better governed, more experienced, and have high past performance. “The labor market is a factor here,” says Begenau. “The labor market for public pension investment talent is not fluid and often has price caps. It is difficult to then expect efficient negotiation outcomes when private equity is on the other side.”

All told, the aggregate amount of forgone capital due in fees is $4.30 per $100 invested, or $19 billion for the entire dataset. This does not necessarily mean pensions are behaving in a suboptimal way, since some may have traded lower fees for access to more skilled fund managers. “If you overpay you may still come out ahead, as paying higher fees may be more attractive than investing in the public markets,” Begenau says.

Ultimately, until there is greater transparency on fees, she says pensions will continue paying different prices for access to private markets.