Those silly fees

October 1, 2013

My earlier piece about the French government’s newly-announced PEA-PME initiative led to a broader discussion about transparency and investment performance.

[By way of recap, I had written that I’m hopeful the PEA-PME could offer indirect benefits to small tech startups that trickle back by helping capitalize downstream companies that are larger and already listed, thus addressing the chronic problem of Alternext liquidity which I’ve discussed before at length. But what I like most about the PEA-PME structure is that it forces the spotlight on performance. That’s because a properly-structured PEA will behave in a way completely transparent to the performance of the underlying asset, just like investing in the stock market directly.]

This broader discussion inspired me to discuss the nefarious effect of fees on investment performance, in homage to Vanguard founder John Bogle. I had promised a real-world quantitative example, so here goes…

In an effort to keep this exercise as simple and straightforward as a blog post should be (the quant jocks out there are welcome to request the full underlying spreadsheet), I’ve decided to benchmark two real-world investment products: i) the Livret A, and ii) a hypothetical fiscal investment vehicle which is representative of many on offer in the market.

First, the Livret A. The Livret A is an interest-bearing savings account whose rate is set by the government. It is fully liquid, meaning the investor can pull out his money at any time without penalty. It is also risk-free, meaning that it is fully-secured by the French government. Because the government offers a higher rate than a standard private bank’s saving account, the total amount one can invest is capped (currently the cap is 22,950€).

The table below depicts the actual investment returns for a person who put 10k€ into a Livret A in January 2003 and held it for 10 years.


As the table shows, the Livret A cash flows are quite straightforward: annual interest payments (inbound) and annual social charges (outbound). For a person that committed 10k€ in January 2003 and left it alone until January 2013, the internal rate of return (IRR) on her investment would be 2.2% per year.

Now by way of comparison, I invented a hypothetical fiscal investment product which is quite representative of those available on the market. This product (let’s call it the ‘vehicle’) locks up the investor’s money for 10 years. As an incentive, it grants the investor an immediate tax credit of 18%. There is a 3.5% entry fee, and a 4% annual management fee (again fairly typical). I assumed no back-end redemption fees. Finally, a performance bonus is paid to the vehicle’s managers of 20% of any capital gains the vehicle generates.

In this simulation, I worked backwards to calculate what this hypothetical vehicle would have to be worth to grant the investor the same 2.2% annual return on his 10k€ investment. The answer: 13,035€, which represents an underlying performance IRR of a whopping 10.63% per year. (Note: this is a hypothetical simulation and not a commentary on any specific vehicle in particular. Although these are representative parameters, the benchmark performance IRR would vary were there interim distributions, a different investment pace, or different fee levels).


Why does the fiscal vehicle need to perform almost 5x better than the Livret A just to match the Livret A’s level of return ?

In one word: fees. Fees undermine the capital-generating potential of the underlying investment, so performance must be that much higher to compensate.

The good news is that such fiscal vehicles often target investments in underlying assets that can achieve high performance, for example high-tech startups.

The more sobering reality, however, is that such fiscal products must not only match the returns of a Livret A, they must shatter them. Why? Because unlike the Livret A, such fiscal products are usually not risk-free, nor are they liquid investments that can be redeemed at a day’s notice.

In a future post I’ll discuss in more detail the concepts of risk, reward, and liquidity.

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posted in venture capital by mark bivens

  • David Jouarisse

    Hi Mark, thanks a lot for sharing this, this is quite interesting and shows concretely that to come back strong and viable, FCPI market should 1- lower their annual fees (fund managers) and 2- the tax incentive be set back to 25% minimum (legislator) to improve the risk return profile of these vehicules. Read my post on Akka Venture Facebook page about how much further the Swedish government has been in that direction this summer: a lot stronger… It would be nice to leave your spreadsheet on google docs in public cloud so we can play with it and better realize what you describe without being mistaken. In reality, isn’t the 4% fees more on the net amount (from previous period) than initial amount; it may change a bit the result and slightly lower this 10% IRR. On top, (12428/5650) puissance (1/10) -1 makes 8% pa. Sure I’ll get that better when I go in the spreadsheet. Last but not the least, I have sent you a great investment case that makes such low IRR look ridiculous and it would be nice to have a chat about it! 🙂

  • I was thinking about writing a piece on FCPI and then you did it. Wonderful!

    I’ve been discussing with my entrepreneur-wannabe fellow MBAs on the general behaviors of French VCs and why there are so few homeruns here. My experience here is still to short to give weight to my words, but they seem to be quite impressed by the unintentional adverse effect, i.e. risk-averse, from the design of this popular vehicle.

    However, on top of the fees, I would argue that the lack of understanding in risk-return and portfolio management of the individual FCPI investors is the worst offender. It could induce significant conflict of interest where investors do not know that they take extreme high risk only to be compensated by a realized return that is higher than most liquid vehicles, and still feel thankful.

    I wonder how real institution investors in France see this? Do they shy away from FCPI funds?

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