Fee Stacks: The Silent Killer of Private Market Returns

If you’ve ever opened a performance report from one of your investments and then been disappointed by the actual dollar amount hitting your bank account, you’ll be very familiar with the concept that fees erode returns.

It’s easy to forget the costs when you look at overall performance numbers – or if you do, perhaps it’s a fairly static percentage cut you have in mind. After all, standard investment types often have fairly basic fee structures, usually just an annual management fee. You can even find passive index-tracking ETFs charging as little as 0.04% pa.

Actively managed funds can vary in the types of fees they charge.

Some may stick with an annual management fee, others may include a performance fee where there’s an extra cost to you if they hit a particular benchmark figure.

When it comes to private market funds, it’s not just the investments that look more complex. The costs of managing these funds can also be more intensive and the fees will reflect this level of active management.

You might hear the word ‘fee stack’ used. This is a common part of investing in private market funds. It’s important to understand what the stack might look like for your selected fund and what that means for your final returns. After all, stellar returns are only exceptional if they both cover your fees and offer you a decent balance after.

What is a Fee Stack in Private Markets?

Just as private market funds invest across a range of structures, their fees and fee stacks can also vary. The fee stack in your chosen fund might include some of these options, or even just a base fee. They might also be referred to as direct and indirect management costs.

You’ll be able to check the full details in the product disclosure statement for your chosen investment. Here are some common terms to watch for.

- Establishment fee: An initial charge to invest in the fund. How often it is charged: Once – on setting up an investment fund.

- Contribution fees: Charges to make additional investments in the fund, usually calculated as a percentage of the additional amount. Charged when making contributions.

- Management fee: A charge for managing the assets in the fund, typically based on the amount you’ve invested. Initially, the fee might be charged on the total capital committed and then later based on net invested capital — the money actually contributed less distributions. Some funds vary their management fees depending on the size of the initial investment and the length of time you intend to invest. Larger investments locked in for longer periods may receive discounted fees compared to smaller or shorter-term investments. Charged annually

- Stepdown fees: Some funds reduce their fees after a certain time period, such as after the initial investment phase. This reflects the lower workload once the fund manager moves from sourcing assets to primarily managing them. Charged annually

- Carried Interest (Carry) (also referred to as a Performance Fee): A performance-based fee tied to the increase in value of the assets in the fund. This usually only applies once a certain threshold is reached, known as a preferred return or hurdle rate. Some funds also apply a high-water mark, meaning if the portfolio previously fell in value, the fund manager cannot charge this fee again until performance exceeds the highest previous value. Charged when the threshold or hurdle rate is reached.

- Clawback provisions: If an investment underperforms, clawback provisions may require the fund manager to return previously charged performance fees or carried interest. Charged when performance falls below a previous level.

- Fund expenses: Operational costs involved in running the fund, such as administration fees and annual audits. These are typically charged to the fund, although some may be passed on to investors as separate charges. Charged annually

- Portfolio company fees: Costs associated with managing the assets held within the fund, such as transaction fees for acquisitions, monitoring fees, or exit fees when selling companies held by the fund. Charged annually

- Withdrawal fees: A fee charged when an investor withdraws money from the fund. Charged when making a withdrawal.

Moneysmart.gov.au offers a basic managed fund fee calculator which can help you estimate your costs on your investment – you’ll note that it doesn’t break out performance fees and hurdles but can give you an estimate of costs.

The performance fees can be the real kicker in your returns – it’s not a guaranteed charge but the good news if you see it in your annual report is that it means your investment has outperformed for the year.

Performance fees act as an incentive for fund managers and can be as high as 20%. It might be applied to all performance once a hurdle is reached, or it can be applied specifically to the performance above the hurdle. The product disclosure document will outline what specifically applies.

To show you how this might look, I’ve taken an example from the Corporate Finance Institute.

A Fund has a 2% management fee and a performance fee (Carry) of 20% charged after the Fund generates an 8% return (the Threshold). It generates a return of 15% for the year. The performance fee applies to the 7% performance above that 8% Threshold/Hurdle.

Evaluating Fees for Returns

What this all means is that fees can be a drag on your managed fund returns, particularly in private market funds which can be more complicated to run and therefore might have a more complicated fee stack.

You’ll need to do your research to understand how the returns measure up to the fees – it doesn’t mean it isn’t worth investing but you’ll have a better concept of the end returns you’ll actually receive and what that means for your broader portfolio.

Some ways to manage this in your portfolio include:

• Compare investment fee stacks and returns to see how competitive your choice of fund is compared to both its peers and other investments in the market. There’s no guarantee that higher fees will offer you better returns.

• Being selective about how you use active management and offset it with passive, lower-cost investments. You can consider fees across your entire portfolio to allow the use of a select actively managed fund with a higher fee stack and balance it with lower-cost instruments.

• Use highly experienced fund managers with a strong track record.

• Make sure that your portfolio suits an allocation to private markets – there are risks involved and it isn’t for everyone. Depending on the size of the investment you are able to make, you may also find the fee stacks simply don’t make it a viable option for you.

Wholesale and institutional investors may find some investment managers offer some discount on management fees for larger investment sizes that are locked in for set periods and this may be something negotiated on an individual basis directly with the fund manager.

Fees and Performance

Investors are often fee-conscious and with good reason when you consider the impact to returns. However, it’s worth remembering that private markets is a niche market requiring expertise and holding complexity in management. Complexity can add cost – and that’s not always a bad thing depending on the exposures you are looking for in your portfolio and the returns you might be able to access.

Considering established fund managers with a strong performance track record and keeping track of how they compare to other options in the market can be a good starting point. Then take the time to consider what the returns might actually look like once you factor the full range of expenses in a good or bad year.

There’s a reason why private market funds aren’t often found in a standard retail portfolio and there’s often a higher entry point for investing, so consider expert advice to ensure whatever you decide, it actually fits within your overall portfolio and meets your individual needs, circumstances and goals.

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.