Private equity using financing 'trick' to boost fees, says Willis Towers Watson

The global adviser to pension schemes, Willis Towers Watson (WTW), has said that private equity managers are making use of financing tricks in order to boost their performance fees.

The firm, along with many globally-focused academics, have accused private equity companies across the world of employing the 'financial engineering technique' which works to 'flatter' their investment returns, thereby helping them to claim higher performance fees, reported the Financial Times.

The private equity managers are said to be making use of bank loans instead of the capital belonging to their clients, in order to pay for their investments. This technique – which is known as subscription line financing – is little-known and allows firms to ask for higher performance fees as a result of internal return rates being linked to investor cash being used.

Andrew Brown, senior consultant at WTW, told the Financial Times: “I suspect that all private equity fund managers are looking into this as they realise that without using subscription line financing, they are being left behind when it comes to their [internal] performance [calculations].

“Private equity managers insist that they are trying to help their investors with managing cash flows, but be under no illusion: this is done to manipulate [internal rate of return calculations] in the early years of a fund’s existence," he added.

Private equity managers have been increasingly turning to this sort of technique due to the current low interest rates, which are enabling banks and other lending institutions to agree bigger levels of loans to fund managers. The cost of overseeing these loans can lower the returns received by investors and they are also responsible for covering the fees and interest on the bank loans, which could put them further out of pocket.

Finance professor at the University of Oxford’s Saïd Business School, Ludovic Phalippou, said that many investors may not fully understand exactly how this sort of financing technique can be positive for their private equity fund manager but negative for the investor themselves.

“With these sorts of tricks, the internal rate of return of a private equity fund can appear stratospheric, even if the amount of money returned net to investors is modest. In some cases, performance fees will be paid when they would not have been due without that trick,” said Mr Phalippou.

In 2013, guidelines were rolled out by US regulators aimed at limiting the level of debt that private equity managers were able to make use of in their deals. The guidelines were rolled out in response to concerns regarding the increasing use of debt to cover the cost of major deals, which could potentially boost investor risk in a turbulent marketplace.

Senior economist at the Center for Economic and Policy Research, Eileen Appelbaum, argued that regulators should “take a closer look” at the use of this sort of financing technique across the buyout industry as it could well be boosting leverage levels in relation to mergers and acquisitions.

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