Or’s Take: Rethinking Private Equity’s Incentive Standard

If you think paying a 20% cut in profits is steep, try paying 25% or 30%, or how about 50%?Ari Rastegar, who worked for Chelsea Hotels Chief Executive Ed Scheetz and real-estate investor Nate Paul, is striking out on his own to raise $250 million to $500 million for a fund that invests in income-producing real-estate assets like self-storage facilities and discount retail locations in secondary and tertiary markets, a person familiar with the situation said.He is proposing a 1.2% management fee, and would take half of the profits above an investment return hurdle of 8%, the person said. The fund also deviates from standard private-equity practice in not charging commissions and fees on acquisitions and add-on purchases, or for monitoring investments, in the hope of ditching the complexities in fee structure and better aligning with investor interests, the person said.Although it is an extreme example, Mr. Rastegar’s fee structure is a reminder that the two-and-20 compensation model that many private-fund managers typically employ is primarily a behavioral norm, albeit one that is deeply entrenched in investor mind-sets.Although a few private-equity firms, such as ABRY Partners, Bain Capital and, more recently, Excellere Partners, have been able to charge a premium carry, they remain rare exceptions in the buyout world. Investors often revolt against higher carry, even when offered in exchange for lower management fees. Despite pressure to lower what are seen as expensive fees in private equity, many limited partners are loathe to take a smaller cut of the spoils in return.Low interest rates and high valuations for quality assets have dented private-equity returns, making LPs all the more focused on lowering the costs associated with their portfolios. As a

result, more LPs have sought separate accounts and co-investments which typically have low, or no, fees associated with them.In a recent mid-year report, data provider Preqin Ltd. found that 16% of 222 active investors surveyed have invested via separate accounts, and half of them have co-invested in individual deals. Those practices are here to stay. Preqin said nearly half of the investors polled believed that separate accounts will be a permanent feature of private equity, and more than a fifth said they are considering co-investing, having not done so before.Such arrangements provide private-equity firms with extra capital to deploy in a competitive market, and give investors a chance to take part in deals with low, or no, fees. But some private-equity executives feel that investors are piggybacking on their expertise and taking advantage of their need to raise money. Privately, some say they would like to charge investors what amounts to a finders’ fee. After all, we provided a service, one executive said.Now that the investor conversation has focused on fees, it is hard to steer it back to performance. Rastegar’s fund is an attempt to do just that. So far, some high net worth investors and one public pension fund, the District Attorneys’ Retirement System of Louisiana, have signed up for the fund.But as the broad market rally continues, it remains to be seen how well Mr. Rastegar’s firm and others will be in convincing investors that the tradeoff of a higher profit share for returns is worth the risk.“General partners who raise funds with exceptionally high carry, can usually only win commitments when they have a great track record combined with well-documented, hard-to-come-by asset improvement skills,” said Antoine Dréan, founder and chairman of fund advisory Triago and of online private-equity fund marketplace Palico.Emphasis on the adjective, hard-to-come-by.

Source: http://www.wsj.com/articles/ors-take-rethinking-private-equitys-incentive-standard-1474025402