Edition: December2015 / February 2016
Editorials

PERFORMANCE FEES

Boomerang effect

One size doesn’t fit all default portfolios. Treasury must think again
on private equity, hedge funds and especially infrastructure.

In its seminal 2011 policy document on better financial services, National Treasury repeatedly and rightly expressed its concern over the “high and opaque” fees being charged by product providers to product consumers. Its latest batch of proposals to address them can throw out a robust baby with the murky bathwater.

“Performance fees are not permitted in default investment portfolios,” states Treasury bluntly. This mooted prohibition should make investors sit up sharply. A blanket ban on performance fees can suffocate private equity and hedge funds, both permitted if not encouraged by Regulation 28 to comprise cumulatively up to 15% of pension funds’ portfolios.

The rationale is to allow greater diversification of asset classes and hence a wider spread of risk. But insist on the wholesale ban and Reg 28, which guides pension funds’ prudential requirements, is undermined. Unlike investment in equities and bonds, where managers can accrue performance fees for tracking an index, such fees are integral to private equity and hedge funds.

Also potentially ominous is application of the ban to “other assets”, capped by Reg 28 at 2,5% of a fund’s portfolio. To the extent that this category refers to direct investment in infrastructure projects, the impact can only be negative; not least for the National Development Plan’s emphasis on job creation, services provision and gdp growth.

Pension funds have the wherewithal and the need to go big-time for infrastructure because of the perfect fit between this macro-economic priority and the investors’ long-term focus. Arguably, infrastructure should not merely be slotted into “other” but categorised as a separate asset class.

It offers pension funds further opportunities for portfolio diversification as well as returns that tend to be stable and predictable. As it stands, Reg 28 provides generously for investment in debt instruments – like government and governmentbacked paper – that might or might not find their way to infrastructure and that might or might not face stakeholder disciplines.

But to get the boost needed, pension funds should be stimulated to invest directly in specific projects where they have ‘line of sight’ participation from inception to conclusion. As renewable energy and similar high-impact projects are initiated by the private sector, investment opportunities will increasingly abound.

Managers must be remunerated, clearly on a basis dissimilar from index tracking. However, a problem with performance fees is that they lack standard definition. Particularly when it comes to “alternative investments” (as Reg 28 categorises private equity, hedge funds and “other”), the meaning and quantification of performance fees can differ from investment to investment. This is because they’re usually subject to negotiation; for instance, on the various levels of performance at which the fees kick in.

Van Wyk . . . slow take-up

In taking aim at all performance fees, the consequence – surely unintended – is for National Treasury to erode objectives that it had legislated by Reg 28 for support by pension funds of “alternative investments”. This is unmitigated by restricting the ban on performance fees to default portfolios only. For it’s safe to assume that the preponderance of portfolios will be defaults.

From the perspective of National Treasury, the ban on performance fees in default portfolios seems logical. Defaults are there, amongst other reasons, to provide for simplicity of choices. Were these fees to apply, and transparently disclosed, the simplicity intended would be defeated.

For purposes of Mr Average Fund Member and probably also Mr Average Fund Trustee, simplicity is virtually unachievable. Moreover, comparison of apples and pears is pointless. Thus much of the logic, in excluding performance fees from default portfolios, is lost.

The so-called “opaqueness” of performance fees is not, or not necessarily, due to managers trying to line up consumers for rip offs. It’s because, by their nature, the methods used for the calculation of performance fees are complex. They vary in terms measuring risk against return, the benchmarks applied, respective funds’ mandates to asset managers and so on.

Take private equity. Broadly, the manager would charge a base annual rate at one or two percentage points of the assets. He’d additionally receive performance fees (known as the “carry” or “carried interest”) once agreed return targets (“hurdle rates”) have been achieved on a successful exit from the investment. Carries and hurdles defy standardisation.

Private equity has begun to flourish in SA. The more it supports venture capital, the better for entrepreneurship too.

Infrastructure investment by pensions funds, however, is far from outgrowing the imposed 2,5% cap. Mark van Wyk and Kasief Isaacs of Mergence Investment Managers estimate that it still represents less than 0,3% of financial institutions’ total asset allocations. This, they say, is despite SA having about R4 trillion in its long-term savings pool and despite government claiming that it has over 600 “shovelready” programmes awaiting implementation.

Arguing in a Glacier by Sanlam research report, they advise trustees: “The first step in making an allocation to infrastructure is to determine what role (it) should play within the portfolio. Once the investment-policy statement has been amended to adjust for the expanded investment universe, a holistic look can help determine how to invest in the asset class. Areas to emphasise involve alignment of interests with managers....”

Back to National Treasury. Rather than an outright prohibition for default portfolios, it could consider instead a cap on performance fees across all portfolios. This might be preferable to it countering objectives that caused it to revise Reg 28 in the first place.