What is it about private debt fees that gives you most cause for concern?

Trevor Castledine, independent investment advisor: My problem is with performance fees. You shouldn’t necessarily be motivating people to stretch for higher risk and more return – unless that’s part of the strategy, of course, but normally it isn’t.

If we do decide that performance fees are acceptable and do align interests appropriately, my problem is that they’re still largely based on a fixed hurdle, whereas, almost exclusively, the underlying positions are floating rate. We shouldn’t be paying performance fees to people just because the Bank of England raised interest rates. It’s not right. It’s just a free lottery ticket for the managers.

So something does need to change. If there is a performance fee, and there might be an argument for it in aligning interests, I think it needs to be based on a floating-rate hurdle. But then it becomes difficult to calculate in terms of who keeps track of it. It brings its own issues.

 

Abhik Das, managing director and head of private debt, Golding Capital Partners: The notion of having some form of flexible hurdle is definitely an interesting development. Both the low interest rate environment in Europe and rising rates in the US have resulted in some managers introducing the concept of a more flexible hurdle. This is something that LPs definitely need to be aware of.

On the question of performance fee or no performance fee, I still think that it’s absolutely essential to have a performance fee, particularly for some of the more niche strategies such as special situations/distressed or structured/subordinated capital, but also for more senior-oriented funds.

I think it is still important that there is some element of alignment of interest so people aren’t just working for the management fee. There is a negative dynamic when you have funds that are purely driven by management fees.

You can see that in their behaviour in terms of essentially pushing money out the door and not necessarily having a long-term view. When it becomes all about deployment, that’s problematic.

I think that’s a particular issue for some of the first-time funds that are new to the market and that need to generate a fee to cover costs. We therefore wouldn’t look at a pure management fee-driven model, even for some of the more “plain vanilla” senior strategies. I think there needs to be some element of a performance fee in there.

 

Gabriella Kindert, non-executive director and supervisory board member, Mizuho Europe: Don’t forget that debt is a fixed-income instrument where you have to mitigate the downside risk. What I have been seeing in the last 10 years, which has been a fascinating time for the evolution of private markets, is that a lot of GPs want to manage instruments where they can generate the highest possible fee. But the vast majority of the economy needs cheaper funding. If you look at the banks, their average interest rate for SME lending is 2 or 3 percent. I feel that there’s a massive need from SMEs that is not serviced because GPs don’t cover the market.

So if we look at mezzanine- or unitranche-type instruments, it’s clear that a performance fee is needed. But for lower-risk debt products, the best measure
is how many losses you had. That’s the banking model we have been using for many years.

 

TC: I tend to vacillate on this. Sometimes I think performance fees are completely wrong. Other times I can happily sit and wonder why all remuneration for performance isn’t based on a target return. If the target return of the fund and the strategy is 6 percent – or LIBOR plus 5 percent, ideally – why wouldn’t you say “OK, the base fee is zero, the hurdle is four and we’ll give you 50 percent of everything over four”? That should really make managers risk averse because they don’t want to suffer losses that eat straight into their fee.

 

Richard Coldwell, portfolio manager, British Business Investments: A key point is that this is an emerging asset class where the returns are more modest and yet fee structures have been structured around private equity-type expectations, and that is not realistic. I agree there has to be some kind of incentive though, otherwise there’s not the same alignment of interest.

 

AD: Private debt covers such a wide spectrum of activity, from senior-oriented strategies to more private equity-type strategies, so I think there need to be different fee structures for different approaches. And, as you say [Richard], the asset class is still relatively young, especially in Europe. As it evolves there will be different fee structures for different types of strategy.

How much has the market evolved so far, and is there a willingness from managers to engage and be innovative on fees?

GK: Different managers have different angles. A lot of people in private debt come from a leveraged finance background, or from CLO or mezzanine or private equity, and they have very different skillsets and different expectations. But I think they quickly realise that unless they have high-return products, they can’t make the economics of the fund work unless they invest in higher-yielding products.

 

RC: There has been a shift from an initial expectation of charging fees on committed capital towards charging fees only on invested capital. Although, in niche strategies there are a number of managers that have to charge on committed capital because otherwise they wouldn’t be able to sustain their teams.

 

TC: They would be able to sustain their teams if they didn’t want to be paid £1 million a year! There’s an unchallenged assumption that people deserve to be paid a huge amount of money and I fundamentally disagree with that.

Similarly, just because you happen to manage a product that delivers 15 percent versus a product that delivers 2 percent, why do you deserve to be paid more money if the effort that you put in and the intellect involved is the same? People don’t deserve to be paid any more, but some see it as the opportunity to exploit the end investor.

Five major talking points

It’s a fix Why are performance fees often based on fixed-rate rather than floating-rate hurdles? More fundamentally, are performance fees justified at all?

Committed to upfront charging When is it justified to charge for committed capital? Should fees be based on invested capital only?

Stellar return, stellar payout Does a GP with a lower target return put in any less effort than a GP with a higher return target? Shouldn’t the fees be the same?

Clear as mud Transparency is lacking, especially in relation to risk. What can LPs do about it?

Not all work is equal Should a constant fee be paid through the life of a fund, or should there be tiered fees based on the effort and skill required at different stages?

What the regulator is starting to do now, with the reform of the role of independent non-executive directors, is going to highlight the importance of assessing value for money for the end investor. If something genuinely takes more effort to do and you need a big team, perhaps because of the origination methodology – so instead of sitting by the phone waiting for it to ring with a team of one, you have 20 people out there sourcing deals – then clearly you’ve got to pay for 20 people instead of one. But if you’ve just got the one person, how can you justify charging the fees that the group of 20 charges?

The argument is that “the return is this, therefore the fee is this” and that, for me, doesn’t compute. If the return is X because the effort is high, of course I’m not suggesting you don’t pay people if they put more effort in. What I’m saying is, I’m not entirely clear that the absolute fee level should simply flow from the return that’s generated.

RC: Our key message is that the fee should cover the cost of the team and there shouldn’t be any excess profit. It should just be covering costs.

 

TC: The fee should cover the cost but then there’s another question, which is whether the cost is reasonable.

 

AD: I think the industry is able to regulate itself and ultimately, as LPs, we all have a choice – we can say yes or no and try to influence things. I think the LP community in the private credit space is getting more educated and ultimately can simply push back if there are certain excesses that happen in terms of fees and how they are structured. If a regulator gets involved, it sends the wrong message. You’ve already seen that fees have come down for some of the senior strategies in Europe.

Between the first fund and successor funds we have witnessed some pressure in terms of fees. In the subordinated space in the US, you had the very earliest funds raising money for pure mezzanine and subordinated capital and charging fees on committed capital.

That had a considerably negative impact on returns and so is basically gone now. The small number of funds still
trying to charge on committed are therefore finding it relatively hard to raise money. So I think ultimately there is a sort of self-regulating mechanism in the market.

RC: I think there has been a reduction in fees over time. If you look at the mega-funds and the success they’ve had in fundraising, there’s very little between them in terms of the fees they charge.

Where there is a challenge is with some of the newer managers operating in niche areas who need to charge a certain fee to make the economics work, but that fee is often not in line with what LPs would expect to pay.

 

GK: We are not operating in a homogeneous market and I think the fee structure should be in line with the value creation and investment philosophy of the manager. Value creation is not only about the return but many other things – such as structuring, ESG considerations, the length of ramp-up time, quality of client servicing, reporting etc – which should be reflected in the potential to charge more fees. Further, if LPs deem that a GP has less counterparty risk with good and reliable service and execution of the mandate, this represents less complexity for them.

 

TC: That’s a genuine cost [reporting]. If you want more sophisticated reporting, it doesn’t just happen by magic. You need extra people or increased expenditure on systems or whatever. I know I’m quite strident on the fee issue, but I’m not suggesting people shouldn’t have their costs covered. There may well be a correlation between a higher return and the work involved in creating it. What’s really important is the assessment of the value for money that’s being provided.

 

AD: At Golding, what we try to do in a market that is relatively non-transparent is to create as much transparency as possible for our clients. If you’re looking at a senior fund focused on direct lending in Europe, you can compare five, six, seven, maybe 10 different funds, and the predecessor funds, and at least see what the fee evolution is or how the fees compare – some benchmarking, in other words. Consultants can help there, and firms like us, and all of us around the table, can assist ourselves.

The main thing we look at is the gross-to-net spread. Ultimately, everyone is looking at putting a target return out there and there are huge discrepancies between the gross-net spread across a variety of managers, and between those people who charge fees on leverage and those who don’t. That gross-net spread is so important because what we are generating for our clients – our pensioners, etc – is a net return for a certain risk.

And that return can have so many differences from one GP to another in terms of determining what actually lands on the table or in the bank account of an investor, which links back to alignment of interests.

Do you think the level of transparency is good enough?

GK: I think transparency overall has improved but, in terms of risk transparency, we’re pretty much in the dark. You can clearly see that credit quality has deteriorated over the last period. So if you talk about the same return then probably you need to achieve it with higher risk, and that kind of transparency does not exist. Rating agencies give indications that they’d love to rate transactions, but are often rejected because the results suggest too low a rating. Risk transparency is missing. This makes it really difficult to compare returns across different managers, strategies and vintages.

 

AD: Everyone has great loss rates today because everyone’s been operating in a pretty benign environment. But what happens when the next crisis comes? I think there will be a correction in the market and there will be some people who will have to exit, but that will hopefully provide a better indication of what’s really happening. It is an emerging asset class and data isn’t perfect. Even on the private equity side, some of the consultants have a lot of data but there are issues about how good the quality of that data is.

Are fees appropriately charged by particular strategies, such as distressed debt?

TC: There are circumstances where it is justifiable to charge a fee on committed rather than invested capital, and you can see bad behaviour potentially being driven by only paying on invested capital.

There might not necessarily be an available deal tomorrow: you’re not sure when it’s going to happen, but people have got to keep their doors open. So, to some extent, paying a fee on committed capital could be defendable. You’re paying an option premium, which means you’ve got the option to invest when the investable event happens and, in the meantime, you’ve got to have the team in place. There’s obviously a cost to that.

When it comes to performance fees, they should take into account that you’ve had to keep this money in cash while waiting for drawdowns. If you’ve committed £10 million [$13 million; €11 million] to someone, you’ve got to keep that £10 million in cash.

While they’re being paid, and until that cash is invested, you’ve got a zero IRR. If the manager then wants to calculate the performance fee based on the time that they have had money in the ground, that’s not quite right because the investor’s IRR includes the period where you’ve got nothing from the manager. That’s something that’s not universally recognised in the market and I think it’s a case of caveat emptor – if you’re going to pay fees on committed capital, you need to make sure that you’re not “double whammied” in terms of performance fees. But in some cases, when the deals need a bit of searching for, there is a cost to running the business and you might not be sure when the money’s going to be invested.

 

GK: I think with committed capital there is an alignment of interest, which is very important.

 

RC: The manager has to demonstrate that it can deliver a clearly differentiated return. If it can’t build that confidence then there isn’t a justification for higher fees because otherwise you just opt for one of the mega-funds in which you have greater confidence.

 

AD: We’re invested in some of the structured capital providers that have a similar style and investment philosophy to private equity, and which can be an alternative to private equity firms in terms of what they provide to businesses.

In terms of their due diligence and the way they approach transactions, it is very similar to a private equity firm. There is a differentiated return and a differentiated proposition, and it is justifiable to have fees on committed capital in that situation.

But some of the funds we’ve seen in that structured capital space have gone through an evolution. Initially they would charge fees on committed capital for the entire life of the fund.

Now you can see that they’re only charging fees on committed capital during the investment period, and then it switches to invested capital after the investment period. I think that is the right answer.

 

TC: There’s a further argument, and I’ve seen it in some cases but not enough cases, that the origination phase is the most cost-intensive and the monitoring and performance phase isn’t that expensive. So maybe at the end of the investment period it’s not just that it switches to invested, but also that the absolute ad valorem level of the fee comes down.

 

AD: Irrespective of invested and committed capital, in our portfolios we’re seeing that some of the managers in the market right now have a tiered fee structure between the investment period and after the investment period. Even to the point where they’re saying for more senior-oriented strategies that they will charge 1.15 percent during the investment period and, say, 1.00 percent thereafter.

I think that kind of thing will happen over time, but less so for first-time managers that are obviously looking to build a business and are often true entrepreneurs. They’re not working off a salary for maybe one or two years.

So again, is it justifiable to charge a fee, maybe even on committed? Yes, potentially, but some of these more established managers, where they’re already on to their third or fourth funds, why should they charge the same fee throughout the life of the fund?
I think that’s a valid question.

 

GK: It can be labour-intensive, though. We are talking about the sub-investment grade part of the portfolio, single B or B-. And it means a 5 percent default rate potentially and there are always two or three fires to put out. My experience of sorting problems is that it’s like originating five new deals.

 

RC: I agree with that. I know the conventional view is that the origination phase takes the resource, but our view across our portfolio is that those funds that deliver excess returns have been the ones that focus on restructuring and portfolio monitoring.

 

TC: The manager has to have all three aspects covered: originating, monitoring and restructuring.

I’ve experienced situations when you have a problem and the front-office team ends up doing the workout and consequently doesn’t do much work originating, so you’ve got a different set of problems. Having that workout capability, even paying for it to do nothing as an option in case something goes wrong, is very important.

I suppose the key point is not so much that it should definitely be cheaper but
that it’s different once you’ve finished
originating.

So do we just look at the fees over the life and say it’s all fungible or do we say we’re going to look at all the different phases of the life and the effort involved and explore the costs of doing that properly?

Every case may well be different, so I guess it’s just a case of not blindly accepting things without justification or using a market benchmark for the cost that’s reasonable without any further investigation.

Richard Coldwell, portfolio manager, British Business Investments

Coldwell is an accountant by background and trained with KPMG. Having initially worked in industry in corporate finance, he spent 10 years with GE Capital in risk management roles. He joined BBI’s predecessor in 2012 to support the development of a portfolio of private debt investments. The organisation is a commercial subsidiary of UK state development body the British Business Bank, which invests in debt structures that provide capital to small and medium-size businesses in the UK.

Abhik Das, managing director and head of private debt, Golding Capital Partners

Das is responsible for the selection, execution and monitoring of private debt fund investments and co-investments, and portfolio management thereafter. He spent five-and-a-half years at BlueBay Asset Management, where he was responsible for primary financings for medium-sized businesses in Europe. He has also worked in Macquarie’s principal finance division, Lehman Brothers’ and Nomura’s leveraged finance divisions, and at Credit Suisse’s investment banking division.

Gabriella Kindert, non-executive director and supervisory board member, Mizuho Europe

Kindert started her career in banking in 1998 at MeesPierson, where she gained insight into asset-based finance, project finance and leveraged finance. She held managerial positions with institutions including Fortis Bank, Fortis Investments, BNP Paribas as global head of loans and, until 2019, at NN IP (formerly ING Investment Management) as head of alternative credit. She is also an expert in fintech alternative lending projects and a senior advisor to several companies.

Trevor Castledine, independent investment advisor

Castledine was investment director for the credit investments of LPPI, the collaboration between Lancashire County Pension Fund and LPFA. He was previously deputy chief investment officer at LCPF and worked in investment banking. At LCPF, he oversaw changes in portfolio strategy and created a £1.5 billion ($1.9 billion; €1.7 billion) alternative credit allocation. He has been a champion of the inclusion of alternative investments to create efficient portfolios and has received numerous industry awards.