Pension funds should seek fee cuts in private markets | Opinion pieces

Investing in private markets, including private equity, private debt, real estate and infrastructure, has helped funds more comfortably meet their return targets in a decade characterized by low returns.

Larger allocations to unlisted assets have also been a key factor in enabling pension funds to weather market volatility caused by the COVID-19 pandemic.

With lower expected future returns in most asset classes, pension funds will be forced to increase their allocation to higher yielding, less volatile and unlisted assets in the years to come. However, the cost of investing in private markets remains extremely high.

For many pension funds, the fees charged by private market funds push the overall balance of costs above what is considered an efficient or acceptable level per member.

This is especially true in the emerging defined contribution sector. However, there is no realistic alternative for most pension funds. Restricting asset allocation to listed assets means having to endure higher volatility and run the risk of not meeting return targets.

The many debates over fee levels, cost transparency and value for money in asset management services have yielded significant results in liquid markets. Faced with the risk of their clients choosing cheap passive strategies, active managers of listed assets have simply had to lower their ad-valorem fees or seek alternative formulas, based on performance.

To a large extent, the same has not happened among private market managers. This is apparently due to the simple fact that institutional demand for private market investments exceeds supply.

However, the dynamics of supply and demand only tell one side of the story. When it comes to high-yielding private equity funds, for example, investors might also be afraid of missing out on returns or engaging in cult behavior towards the asset class. Perhaps this is the reason why the largest funds experience the greatest inflows of assets.

Additionally, while the transparency of private equity funds has improved dramatically over the years, there has been little differentiation in fee structures. The typical manager continues to offer the traditional two-and-twenty structure.

Pension funds that have no choice but to invest in the private markets should vigorously seek solutions to reduce their costs associated with such investments. Among these, they must ensure a fair distribution of the outperformance generated by the managers.

Another possibility is to join forces with other investors, through co-investments or other structures, in order to obtain a leverage effect from private capital managers. The added risk of working with smaller, less established private equity funds must also be weighed against the lower fees they charge.

Whatever the practical solution, pension funds have the right, and to some extent the duty, to charge lower fees individually and collectively. The private capital industry could be booming. But this is no reason why members of pension funds should bear the cost of too high asset management fees to ensure adequate retirement.

Carlo Svaluto Moreolo, Senior Editor,
[email protected]