Keating and Clacher on excluding performance fees from the charge cap.


Iain Clacher and Con Keating

This blog is the responses from Con Keating and Iain Clacher to the second Government consultation on the exclusion of performance fees from the charge cap announced in the 2021 budget . You can read “Enabling investment in productive finance” here.

It is their third blog on this subject; earlier blogs question  “how productive is productive capital” and ask us to follow the data and defend the charge cap. 

Taken together they form a powerful counterweight to Government’s proposals to leave the inclusion of illiquids in our DC workplace pensions to the market

Responses to questions in “Enabling investment in productive finance” (Keating and Clacher)

We responded negatively to the earlier consultation, arguing that the charge cap should not be relaxed. We continue to hold that position and believe that the arguments we advanced against relaxation apply with no less force to the proposed exemption of certain forms of investment from the charge cap. It is worth emphasising again that we believe the charge cap has been a highly effective piece of consumer protection regulation. This is especially true at a time when significant amounts of savers have only just started saving regularly for their pension due to the success of automatic enrolment, but when contribution rates still remain significantly below what would be considered an adequate savings rate.

We find little or no support for the private equity industry’s claims to be adding value to the companies and securities in which they invest. As these claims underpin their arguments in favour of ‘performance’ fees, we believe that investment structures of this form are wholly inappropriate for DC pension funds.

The problem is rather less the classic ‘run-on-the-fund’ such as we saw with the Woodford funds, though forms of that are possible, but rather more the effect on DC scheme member confidence. If fund valuations are over-optimistic, members are likely to be over-confident and save less, at a time when many are not saving enough. If the over-optimism in valuation only comes to light in a day of reckoning at the end of the contract, it is simply too late to repair the damage.

We also worry that continuation funds may allow managers to extract unwarranted performance fees while deferring losses to later generations of fund holders, who would have no recourse for recompense.

The industry claims that performance fees align the interests of investor and fund manager, of limited and general partners. That may be, in part, true, but it comes at the cost of incentivising managers to overstate the performance and value of the fund, throughout the life of the fund. But, under how many performance fee structures does the fund manager have ‘skin in the game’? Performance fees create an incentive to take more risk with other people’s money. If the bet pays off, collect your performance fee. If the bet does not, the investor loses real money. The fund manager has not lost any money unless it has ‘skin in the game’.

There are also potential conflicts of interest as the SEC notes:

“Private equity firms often have interests that are in conflict with the funds they manage and, by extension, the limited partners invested in the funds. Private equity firms may be managing multiple private equity funds as well as a number of portfolio companies. The funds typically pay the private equity firm for advisory services. In addition, the portfolio companies may also pay the private equity firm for services such as managing and monitoring the portfolio company. Affiliates of the private equity firm may also play a role as service providers to the funds or the portfolio companies. As fiduciaries, advisers must make full disclosure of all conflicts of interest between themselves and the funds they manage in order to get informed consent.”

While the manager’s carried interest may only be removed from the fund at maturity of the fund, the overstatement of interim values will have created extra revenues from the ad valorem element of the fee structure. We have seen many corrections to valuation taken as losses in the current usually final reporting period, we have seen no restatements of prior valuations. Figure 8 earlier shows the distribution of performance fees or “carry”.

In addition, the overstatement of profitability increases the apparent value of the stock of the management group, making it more attractive than warranted in stock-based acquisitions. The private equity industry has, in recent years, been acquiring traditional fund managers in ‘paper-based’ transactions at a remarkable pace.

Before moving to the specific questions in the consultation, it is worth noting that these questions are limiting the scope of response to those who are managers or trustees of pension funds, or similar. This, therefore, excludes a wider set of expertise and evidence that may be relevant to understanding the complexities and relative costs and benefits to the proposal. The questions below have therefore been answered based on the experience of one of the authors running a Family Office and DB pension funds.

Question 1a: Would adding performance-based fees to the list of charges which are outside the scope of the charge cap increase your capacity and appetite, as a DC scheme, to invest in assets like private equity and venture capital?

Clearly, removal of these classes of charges and fees from the scope of the cap would enhance the capacity of our DC schemes to make and hold these investments, but it would not enhance our appetite. Some such as VC with their lottery-like pay-off profile will remain wholly inappropriate for any form of pension scheme. Similar doubts exist with respect to early-stage investment in infrastructure; cost escalations and construction time over-runs, particularly in larger projects, are commonplace. In these cases, equity is wiped out and debt written down severely. The story of Eurotunnel is worth remembering.

Indeed, exemption from the charge cap would reduce our appetite for them in our DB funds and Family Office portfolio.

As is evident from the trade press ‘news’ stories, papers and webinars, the mere prospect of this removal has seen a plethora of new entrants to these markets, with traditional fund managers, in particular, looking to expand their range of activities into these markets. It is clear that the asset management industry sees private investment by DC schemes as a major opportunity; one they are actively encouraging. Quite how these new entrants propose to justify their use of performance fees is not yet clear.

The private equity industry has, by some accounts, more than one trillion US dollars of ‘dry powder’, funds available for investment.[1] Competition is already extremely high; the terms on which transactions are being finalised make them extremely expensive for investors. It is notable that foreign competition has displaced UK investors in much domestic infrastructure investment[2]. Adding further funding from UK DC schemes can only exacerbate that. It seems that international competition for UK infrastructure assets is causing many UK investors to look overseas.

Are you already investing in assets like private equity and venture capital, and if so would this change increase how much you invest?

We have long invested in illiquid instruments for our DB funds and Family Office. In addition to commercial and residential property, we have also participated in fixed income private placements and have opportunistically bought private debt in the secondary markets. We have never paid a performance fee on any of these investments.

We do not invest in debt funds and if we were to do so, we would certainly not offer performance fees to the managers. Unless the fund is buying exclusively in the secondary markets, any excess returns can only come from the company receiving the investment. Charging companies in this manner would be detrimental to its productivity and possibly to employment and the community. If the purchases are secondary market purchases, they have no impact on the company’s finances or productivity. Table C2 later compares private debt performance with a range of fixed income comparators – there appears to be little advantage gained relative to these liquid traditional methods at the gross level and at the net after fees level, some underperformance. With costs and fees at four to ten times those of traditional fund management, these clearly represent an extremely poor value for money.

We have never bought VC for the DB funds. We have been active in VC for the Family Office since 1982 and have made a total of 217 distinct direct investments over that time. 29 of these proved total write-offs. Just 11 of those investments returned more than 100% and these accounted for all the outperformance relative to listed equity. Initially, we had a policy of participating in second and subsequent round financings of investee companies but abandoned that policy as the valuations of those financings grew to levels we believed far too high. We have sold all these investments, in many cases, and particularly the lack-lustre ones, to the management of the company. We completed the sale of our last direct investment three years ago.

In recent years, we have investigated the markets for ‘follow-on’ financing but on the few occasions when we made offers, we were outbid by sovereign wealth funds. For both the pension fund and Family Office fund, we have bought private equity and hedge funds since the early 1980s but no longer own any. The motivation for ceasing was disappointment with the performance achieved.

If you do not currently invest in such assets would this change make it more likely for you to, and do you have an idea of to what % of AUM that might be?

We do not currently have any of these assets, and this proposed change would reinforce our decision not to buy. Furthermore, it would add to our currently active consideration of sale of the UK listed equities we currently own.

Question 1b: Would adding performance-based fees from the list of charges which are outside of the scope of the charge cap incentivise private equity and venture capital managers to change their fee structures?

No. It is most likely to have the opposite effect, encouraging private equity and venture capital managers to resist pressures to lower fees.

Question 1c: If you do not believe that the proposal outlined in this consultation is the right solution to the barrier posed by the regulatory charge cap, what might be a more effective solution?

The charge cap serves its purpose – protecting pension savers. It has contributed to the lowering of costs of DC schemes. Performance fees operate at multiples of the fees currently charged for traditional asset portfolios and there is no substantial or sustained evidence that this is warranted.

Diverting pension savings from traditional assets such as equity has already damaged the standing of the London Stock Exchange, exempting these asset classes will add to that damage. There is already a structure which would serve DC investors well – the listed investment trust. These could hold as their assets one or more of these funds, with those funds charging performance fees. The listed equity would have the advantage that it would have a quoted price at which investors might sell if they so wished and moreover the price itself would carry information with respect to the market’s view of the performance of the investment trust’s investments, and the quality of the manager’s valuations. Some do already exist – see Citywire’s best investment trusts.

If the DC investor’s retirement account is invested in an index tracking fund that includes the FTSE All-Share Index, the DC investor will already have some exposure via these investment trusts to private equity and venture capital.

The question which should be asked is why the managers of these illiquid funds resist listing as investment trusts – one cannot help but wonder if they wish to avoid the scrutiny.

Question 2: How can we ensure members of occupational DC pension schemes invested in default funds are sufficiently protected from high charges, whilst adding the performance related element of performance fees to the list of charges outside the scope of the charge cap?

The short answer is that it cannot be done. Using hurdle rates is simply recognition that performance fees are inappropriate for the range of returns below that rate. It is rather less that high charges are to be avoided, but rather more inappropriate performance fees.

Question 2a: Do you have any suggestions for how we can ensure that the regulations ensure members are only required to pay fees when genuinely realised outperformance is achieved?

It would be extremely difficult to base ad valorem fees solely on realised values – in traditional fund management they are based on unrealised market prices for the portfolio held, and the implicit understanding is that this could have been realised. The problem with private illiquid values is that these may prove spurious.

This is not a problem for carried interest if all carried interest is held, perhaps in an escrow account, until the final liquidation and wind-up of the fund; the final valuation might then show a large loss correcting earlier over-estimates (and many do show such losses).

Using an external pricing source or basing fees on audited values would raise questions as to the frequency (and therefore cost) of these valuations. For ad valorem fees, it should be possible to allow the drawing of these fees provisionally based on the manager’s valuation, and for the auditor’s value then to override requiring the immediate repayment of anything in excess of that due under the auditor’s valuation.

Distributions made prior to the maturity of the commitment are also potentially problematic and can affect the estimate of the return earned over the life of the fund. Distributions are usually part repayment of funds invested and part return on an investment, but it is not always simple to establish this distinction. Distributions may take the form of cash or stock and are not always final – they may be in part or wholly recallable.

Furthermore, there are some issues with leverage. It is well documented that private equity held companies have about twice the indebtedness of listed companies, and though that may raise questions as to the true value-added of a manager, it is leverage within the fund which is the issue – so-called subscription lines. Where these function as originally intended (short-term bridge finance) they are not problematic, but at longer maturities this is gearing and usually occupies a senior position in the creditor hierarchy.

The internal leverage of private equity is best measured by the net debt to EBITDA ratio; this is shown in Figure 9.

Figure 9: Net debt to EBITDA ratio

Net debt to EBITDA ratios in excess of 3 are usually considered problematic, with the exception of highly regulated industries such as utilities. To offer some comparisons, firstly as interest rates have declined companies have increased their levels of borrowing – over the past twenty years, the net debt/EBITDA ratio of the S&P 500 has increased from 1.5 to 2.3. Table 5 below shows the ratios for a selection of London market indices. It is only real estate and regulated utilities, with their stable income flows which have comparable debt ratios to those of private equity.

Table 5: Net Debt / EBITDA ratios 2021

FTSE All-Share Index 0.48
FTSE All-Share Real Estate Investment Trust 6.17
FTSE All-Share Gas, Water and Utilities 6.47
FTSE All-Share Consumer Discretionary 3.19
FTSE All-Share Pharmaceuticals 2.31
FTSE All-Share Retailers Index 1.55
FTSE All-Share Industrial Engineering 1.19
FTSE All-Share Technology Hardware and Equipment 2.38
FTSE All-Share Basic Materials 0.55
FTSE All-Share Telecommunications 3.01
FTSE All-Share Utilities Index 5.08

Source: London Stock Exchange

Incidentally these levels of internal and external leverage render untenable the private equity industry’s claim that private equity is less risky or less volatile than listed equity. These leveraged companies are more precarious than their listed counterparts – and with that employment and their role in the community is also more precarious. The need for an investee company to support the debt service of fund borrowings adds to it precarity.

The leverage also reduces the amount of tax paid, where the interest is tax-deductible from UK profits and is paid free of UK withholding tax to an offshore company based in a low tax jurisdiction, and so amounts to a taxpayer subsidy under which gains are privatised and the losses are borne directly or indirectly by the taxpayer[3] when the overleveraged company fails.[4]

We are sorry to say that we have never seen a wholly satisfactory and universally applicable method of calculating the returns of a private illiquid fund. Even if we confine ourselves to the ex-post evaluation when all cash flows are known, the different timings of distributions can make comparison of different funds impossible.

All of these problems go away for the investor if the investment takes the form of an investment trust, though of course they remain for the investment trust itself.

Question 3: Which of these conditions should the government apply to the types of performance-based fees that are excluded from the list of charges subject to the charge cap? Are there other conditions we should consider? If supported by guidance on acceptable structures would this give confidence to more schemes?

We do not support the idea of excluding any performance fee-based investments from the charge cap. If there are to be exemptions, then it should be incumbent on the fund manager to also report the return experienced by the investor based on their notional committed funds, while performance fees are based on drawn and invested funds. It would be necessary to specify the cost of committed undrawn funds to investors to do this.

At a more basic level, the valuation of the fund should be audited at least annually. The cost of audit should be borne by the fund manager or general partner.

These actions would tend to increase investor confidence.

Question 4: Do you agree with our proposal to require disclosure of performance fees if they are outside the scope of the charge cap?

If performance fees are outside of the cap, they should certainly be disclosed. Any ad valorem fees should remain within the cap, as appears to be proposed.

We have been unable to reproduce the figures quoted in the consultation for fees within and outwith the cap – for example, in the 2 + 20 instance, our calculations for the all-within-cap variation show fees at 85.3 basis points on the initial investment and 78.4 basis points on the net residual one year value.

We would also make the point that with the return assumptions made, and no rebalancing possible in reality, the portfolio will over time skew to higher allocation to VC.  After one year the portfolio is 10.6% VC.

If so, we propose this is done in a similar way to transaction costs – do you agree?


Could you provide details of any new financial costs that could arise from a requirement to disclose performance fees? Please outline any one-off and ongoing costs.

The performance fee is already calculated by the fund manager. Its disclosure would have no additional costs.

Question 5a: If we add performance fees to the list of charges which are not subject to the charge cap, do you agree that we should remove the performance fee smoothing mechanism and the pro-rating easement from the Charges and Governance Regulations 2015?


Question 5b: Is there a need for transitional protection arrangements to be brought in for schemes that have decided to make use of the performance fee smoothing mechanism, and if so what do these transitional arrangements look like?

We believe that very few schemes, if any, have availed themselves of the smoothing mechanism. If they have investments with fees being treated in that way, there is no need for any transitional – existing investments being accounted for under that simply ceased to be counted in that manner once the exemption is introduced.

As several of our reviewers suggested that we should include this, Box 1 below contains the form of fee structure we believe necessary to protect DC pension investors.


[1] .  The BIS quarterly review reports “dry powder” globally as being $3.18 trillion citing Pitchbook data.

[2] see the further discussion in the House of Commons Work and Pensions Committee ‘Pensions stewardship and COP26’ Report published on 30 September 2021 at Chapter 4

[3] Source:

[4] We note that HMRC has recently limited the deductibility of interest to 30% of an investee company’s EBITDA in any given year.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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