“Incurrence” is a bizarre word. It is mostly used in the investment markets and typically in relation to debt.
It is used by the Pensions Minister in announcing the draft regulations that will enable DC schemes to voluntarily incur fees on investments that would normally be considered undesirable.
“That is why I am bringing forward draft regulations, building on the policy proposed previously by the government, which would allow schemes to smooth the incurrence of performance fees, which are often payable on illiquid investments, over five years.
“The hope is that this will give trustees, especially those who might be unsure about investing in illiquid assets, greater confidence to make that leap, safe in the knowledge that they can deliver the best possible return for their members.”
There is an unusual passivity about this statement. Nowhere in the Government’s consultations on the charge cap do I read a justification of the payment of performance fees on illiquid investments, it appears to be one of those immutable truths that you don’t argue with. But isn’t the job of a purchaser to push back on such matters. If you can’t understand why you are paying some fees, then shouldn’t you avoid the investment?
Reading the latest consultation response, I don’t hear much from the common investor, the arguments seem to be going on at a much higher level. But this is about our money and we need to be bought in. I think the Government and other key contributors to this consultation should be addressing legitimate questions from ordinary people. So here goes!
Why performance fees in the first place?
I haven’t seen the argument for performance fees in the consultation.
The argument is put elsewhere, this article puts it very succinctly
The purpose of a private equity or hedge fund is to raise capital, invest that capital, and earn a rate of return higher than conventional investments. The success or failure of a private equity or hedge fund is highly dependent upon the capabilities of the manager. Accordingly, certain vehicles have been developed in order to reward the managers of these funds for the successful deployment of the fund’s capital. These vehicles include a carried interest in a private equity fund and a performance fee in a hedge fund.
But there is something here that should worry any saver. The payment of these fees seems to be justified by superior knowledge and expertise of the investor (otherwise why employ a fund manager). In Nest’s recent investment in alternative energy sources, Nest chose to employ Octopus as its partner who would normally be expected to be rewarded on performance, do Octopus know more on this than Nest- yes, does Nest pay performance fees – I don’t know, should Nest pay performance fees – only if it is the interests of its members to do so.
The further consultation response (this one is additional to the response in January) more of less accepts that performance fees are indisputable and the reason for its further consultation was that
The government wanted to understand the degree to which the long-term nature of illiquid investments and the resulting long accrual periods for performance fees posed a problem when calculating charges. Some stakeholders had raised with us the prospect that the charge cap prevented trustees from exploring investments that incurred performance fees.
The result of this further consultation is that the Government intends to change the rules for the charge cap so that the performance fees can be reported over a five year period , even if paid in just one. To me, the case for the payment of performance fees remains unclear especially if the means for calculation of those fees is devised and maintained by the asset managers (as suggested by the Partners Group- (asset managers)
One way to achieve this might be using existing, agreed calculation methodologies and bases for these methodologies that asset managers are comfortable and confident providing consistently across their client base.
Just who is the master here and who the slave? How are the laws of agency being applied? Is there a way of clawing back fees paid, if what looked good, turns out to be ruinously bad?
I am with NOW pensions in questioning whether the cost to the integrity of the charge cap is worth pandering to the needs of the hedge fund managers
We question whether the easement goes against the intent of the charge cap. The charge cap is simple to calculate and explain, particularly to members. The easement introduces complexity which potentially undermines the protection afforded to members.
But I am prepared to be convinced that this easement is necessary provided I get a proper argument for why performance fees are necessary and then the reassurance that those purchasing these investments are fit and proper. Hymans Robertson make a very sensible statement on this second point which is quoted in the latest consultation response.
In terms of the level of charges, this is heavily influenced by scale. With relatively small proportions of assets allocated to illiquid investments, it is mainly larger schemes that have sufficient scale to access illiquids
Nest are targeting 15% of their total assets being invested in illiquids, by the time they get there then Nest will have more than 20m GBP to invest so 15% represents at least 3bn GBP.
Couldn’t Nest build in an agreement with Octopus, that where there is such wild success that Octopus could be paid a performance fee that breached Nest’s covenant on the charge cap, that fee in itself was capped?
I consider Nest to have sufficient expertise to negotiate a decent deal and to decide whether to pay performance fees or not, if it is in the interests of members to do so, then Nest should act in the interests of its members but it would be a pretty huge spike in fees that would breach Nest’s default charge cap (98% of Nest investments are reported to be in its default).
There is a broader question about the trustee’s need to redeem these assets to pay claims (transfers). This is cleverly summed up in this tweet
The private space has so many extra risks that the additional fees are really only likely to be worth it where the possible duration for that bucket is “forever”. I suspect these fiduciaries don’t have that duration, and are therefore paying more for risk they don’t need.
— Seven Dollar Millionaire 💸💸💸💸💸💸💸 (@7Millionaire1) March 22, 2021
The problem occurs when the claim becomes the norm, as in the transfer away from the scheme when a saver reaches retirement. The argument for illiquids becomes considerably stronger where the scheme pays the pension – as in a collective DC Scheme.
If the Government’s predilection for illiquids is based on its assumption that most of the large schemes it is fostering will pay scheme pensions, then the issues around “forever” fall away. The consultation does not make this clear, perhaps it should.
Why should performance fees bite?
Performance fees would only bite where performance was stellar and illiquids made up the majority of the default. But stellar performance is not usually a matter of manager skill, it is more to do with a freak event and such speak events can cause crevices as well as spikes.
Trustees have much more to worry about when investing in illiquids than the technical issue of breaching a charge cap, indeed the performance fees argument seems to pale into insignificance when you consider issues like the failure of a Woodford or more recently Greensill.
If the point of DC consolidation is to leave DC investment in the hands of the CIOs of a few master trusts, what is the market for hedge fund managers to target where their fees could breach the cap? My worry is that the hedge fund managers are really targeting much smaller schemes who may feel they want to play with the big boys without either the assets or the expertise.
Why should we want to incur high fees?
I am sure I am not alone in being baffled. I don’t understand
- Why illiquids have to use performance fees?
- Why these fees cannot themselves be capped?
- How they might breach the charge cap when they only pertain to a small part of the default?
I’d be really keen to publish a technical argument (couched in language the common reader can understand) that addresses these three questions.
Until I have answers to these questions in my head, I remain concerned that this fee consultation is unduly passive and that there is insufficient push-back on hedge fund managers. Hedge fund managers like to think of themselves as masters of the universe but that doesn’t mean they are!