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Private Equity Profits Called into Question

Private equity has proved better at enriching its own managers than producing investment profits for U.S. pension funds over the past decade, according to a study prepared for the Financial Times by academics at Yale and Maastricht University.

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The industry faces mounting political scrutiny as the presidential candidacy of Mitt Romney, a former private equity executive, has drawn attention to its business model and favorable tax treatment. Mr. Romney released his tax returns after pressure from Republican challengers.

From 2001 to 2010, U.S. pension plans on average made 4.5 percent a year, after fees, from their investments in private equity. In that period, the pension funds paid an average 4 percent of invested capital each year in management fees. On top of those, private equity often collects a variety of other fees and a fifth of investment profits.

“Assuming a normal 20 percent performance fee, this would amount to about 70 percent of gross investment performance being paid in fees over the past 10 years,” said Professor Martijn Cremers of Yale.

Private equity describes its fees as “two and twenty”, a 2 percent management fee and 20 percent share of profits. However, the management fee is usually calculated as a proportion of total capital committed by the investor, which takes time to invest.

So in the early years, the management fee can be a much higher proportion of actual cash invested. For instance, if a $1 billion fund invests $100 million in its first year, the $20 million management fee would be 2 percent of committed capital, but 20 percent of invested capital for that year.

From 1991 to 2000, U.S. pension funds paid an average 2 percent of invested capital each year in management fees, and received 21 percent returns, after fees, annually from their private equity investments, according to data from the CEM Benchmarking database used for the study. The database covers about a third of US pension fund assets.

The rise in management fees since 2000 may reflect greater fundraising, meaning that more funds are in the early investment phase when fees are high. The increased use of third-party fund of funds to invest in private equity could also have added an extra layer of fees.

The Private Equity Growth Capital Council, a trade body, said that calculating fees on the basis of committed capital was the industry standard, and it was inappropriate to compare fees on the basis of invested capital.