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The 80/20 Rule

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Why the biggest investment costs are also the hardest to understand 

The 80/20 rule, or ‘Pareto Principle’, states that the majority of results come from a minority of causes. For example, 80% of wealth is owned by 20% of the population.

The same is true of investment costs: if 20% of assets are invested in private markets (private equity, private debt, infrastructure, real estate etc) they may well account for 80% of total costs. 

To make sense of investment costs we need data. The CTI templates are changing the landscape and enabling funds to access cost information more readily. Before CTI even existed, the Institutional Limited Partners Association (ILPA) introduced a global template, which has been a real step forward for transparency. 

At CEM we work with both ILPA and CTI templates. Managers are willing to supply them, particularly CTI templates in public markets where compliance is good. However, it’s much harder in private markets and globally the ILPA template hasn’t proved a silver bullet.

It’s important to say that most General Partners (GPs – fund managers for private assets) are complying willingly with requests for data via the templates. Some however are not and we have seen pushback for a variety of reasons, e.g., ‘everything you need is in the financial statements’ or ‘please see our website’. Some simply don’t respond at all.

So why is it so hard? Some big funds work with a handful of public market managers who have a UK presence and are generally well resourced. The fund however may invest in hundreds of GPs globally. Sourcing detailed breakdowns of costs for each template can be a significant undertaking and far from straight forward.

·       Lack of incentive – Returns in some private asset classes have been great for a sustained period. Consequently, great waves of money have flowed into private markets. Demand significantly outstrips supply. The level of ‘dry powder’ (committed capital that hasn’t yet been ‘drawn down’ by the GPs) is now at $2.3 trillion and rising – there is twice as much money committed globally as there is ‘in the ground’ [Source: McKinsey Global Private Markets Review 2020].  This has created a huge imbalance of interests between investors and GPs. Many GPs can pick and choose the pension funds they want to work with, so they have little or no incentive to complete templates.
·       Lack of resources - GPs tend to be smaller than their public equity counterparts and may lack the resources to respond to multiple requests. 
·       Lack of consistency – The definition of full transparency isn’t universally agreed upon. CTI came on top of ILPA and adds another ‘standard’. Some funds have developed their own templates. GPs complain, not unreasonably, about the lack of consistency on the part of investors in terms of their demands for reporting. 
·       Geography - GPs are often based in different countries to their LPs; making it difficult to exert regulatory pressure to respond to data requests. 

So, after explaining to a top Wall Street GP what a CTI template is, convincing them to complete it can be just a step too far.  In any event, finding these costs is only half the battle. Making sense of them is something else entirely. Private market cost structures are inherently complex, making it difficult to understand what’s going on and what is a cost.  Some of the challenges include:

·       Complexity – On top of the base fees and performance fees (carried interest), there are a variety of different direct and indirect costs such as set up, due diligence, break-up, and monitoring. 

·       Share of revenues - GPs often earn fees from running the companies that make up the private equity portfolio. If a GP isn’t set up to provide full transparency, these costs can be difficult to find (sometimes requiring looking beyond partnership’s financial statements to portfolio company statements).

·       Treatment of rebates - The investor is also entitled to a share of the revenue, but this is generally not actually transferred to them. It is instead held by the GP as a payment towards gross management fees. When reporting management fees, many exclude the withheld ‘rebate’ and report a net fee, making it difficult to calculate the gross fee.

Private market data is essential to give investors the full picture on their costs and how they compare with others: better information leads to better insight, more informed decisions and ultimately a better result for all stakeholders. 

David Jennings, Client Relationships Manager & Joao Barata, Analyst at CEM Benchmarking