Key Points:
- Private capital firms accumulate wealth regardless of the risk-return trade-off of their portfolios.
- Fund managers offload investment risk by diversifying their investments and limiting their losses through co-investment.
- Private equity firms can tilt the balance in their favor by using leverage, but this can also increase the likelihood of default.
- The private capital wealth equation relies on management rights and controls rather than ownership rights and private property.
- Fund managers earn significant fees, including annual management commissions and performance fees.
- Fees charged by alternative managers can sometimes be opaque, leading to hidden fees and potential overcharging.
- In private markets, long-term commitments provide a recurring flow of income and better economics than other asset classes.
What makes financial capitalism so compelling is the idea that modern fund managers fully participate in the upside of their investment decisions with limited exposure to the downside. This model helps maximize the economics of the trade.
Private capital firms accumulate wealth regardless of the underlying portfolio’s risk-return trade-off. The performance of alternative asset managers can be encapsulated in the formula: Wealth = Controls + Economics.
Offloading Investment Risk
One way for alternative managers to diversify risk is by investing in many corporations or start-ups that compete in the same sector. This approach improves their odds of making money. Additionally, fund managers’ share of losses is limited to the portion of their annual bonuses derived from management fees charged on their clients’ capital commitments. This token participation gives the appearance of alignment of interests, but the managers’ odds are better than those of their investors.
Another way private equity firms can tilt the balance in their favor is by financing buyouts with leverage. However, excess leverage can amplify financial stress and increase the likelihood of default.
Management, Not Ownership
Capitalism has evolved to rely on management rights and controls rather than ownership rights and private property. Fund managers have the right to use their clients’ assets and levy fees on capital commitments. The economics variable is driven by rent extraction through long-term contractual access to assets.
Multi-Layered Charges
Alternative fund managers’ fee-based model includes annual management commissions (AMCs) ranging from 1% to 2% of assets under management (AUMs) in private equity and private debt. Additionally, performance fees (carried interest) grant managers the right to capital gains above a certain rate of return guaranteed to investors. Ancillary fees, such as monitoring, consulting, and advisory fees, can also contribute to fund managers’ earnings. The fee-centric model relies on inertia and a lack of liquidity in private markets.
Fee Overcharging
The terms and conditions of commissions charged by fund managers can lead to hidden fees and other expenses. Some of the largest global private capital firms have faced allegations of overcharging and have reached settlements with regulatory authorities.
Tithing Investors
The alternative management model operates like a form of tithing, with fund managers earning combined fees on the proceeds distributed to investors. Private markets provide a recurring flow of income and better economics than other asset classes.
Overall, the private capital wealth equation relies on management rights and controls, significant fees, and long-term commitments that provide a recurring flow of income.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
