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Getting fat on fees?

The management fees charged by private equity firms have come under increased scrutiny by investors as fund sizes have crept up. But what of the amounts charged to portfolio companies in the form of transaction fees, monitoring fees, directors' fees, and so on?

One of the largest surprises for many investors new to private equity has to be the size of management fee that funds charge. Newcomers look at the three to five basis point charges levied by fund managers in other asset classes and baulk at the 1.5 per cent to 2.5 per cent of the fund under management that private equity investment costs. We've all heard the arguments as to why private equity is generally a more expensive investment to make. We've also heard the debates about economy of scale and why larger funds should reduce the percentage charged to their investors.

But what many newcomers may not appreciate is that private equity firms - buy-out firms specifically - often have a number of income streams other than straight management fees. We're talking here about the myriad fees charged to their portfolio companies.

There is no standard in the industry as to what firms will bill companies for. But the most common of these fees tend to be: transaction fees to cover the cost of doing a deal; monitoring fees for services provided to the company; and directors' fees, a salary paid by the business to a private equity professional sitting on its board. There are a host of others besides, including capital structuring costs, head hunting and consulting fees… the list goes on.

In an environment in which the alignment of interest between investors and fund managers is under increased scrutiny, the fact that firms are charging not only their limited partners but also their portfolio companies to cover the cost of doing business has become ‘something of a hot topic', according to Rho Fund Investors' Gordon Hargraves. ‘People didn't pay as much attention to it in the past,' he says. ‘But now that the asset class has become more sophisticated, liquidity is proving harder to achieve and that allocations to private equity are creeping downwards, investors are looking at funds more closely. They are looking more at alignment of interest. Investors are much more sensitive now about the fact that certain GPs may be getting wealthy without making good returns.'

How much?
The point is that it is theoretically possible for firms to earn up to four per cent of a fund total in its early years simply from the fees it charges to investors and portfolio companies. If a $500m fund charges a two per cent management fee, for example, it will receive $10m from its investors. If it then completes four $125m deals a year and charges its portfolio companies an average of 1.4 per cent of the deal total, it will receive roughly $7m a year. Then there are the monitoring costs of, say, ten companies at $250,000 each a year, adding up to a further $2.5m. There could also be further fees on top of this.

These numbers may sound on the high side, but an independent study of 72 transactions by US lawyers Dechert backs them up. It found that the average transaction fee charged by private equity firms was 1.37 per cent of the deal size and that this varied very little from the smallest through to the largest deals. ‘In a market in which there is no real standard, we were very surprised by the consistency of the transaction fee charged in control acquisitions,' says Dechert's Robert Seber, one of the report's authors. ‘These fees are highly correlated to transaction volume.'

In a separate but related study, the firm also looked at monitoring fees. The study found that monitoring fees were not correlated to the size of the portfolio company. In fact, they ranged from 0.24 per cent of a company's EBITDA up to 4.37 per cent. But possibly more interesting than the level of monitoring fees charged by private equity firms is the ways in which they charge. ‘One of the issues with monitoring fees is how long a firm will charge their portfolio company and when they seek payment,' says Seber. ‘We found that one large buy-out firm charged theirs up-front, but most do so on an annual basis over three to five years. Some may charge for longer if the ownership structure of the company doesn't change in that time. But generally, they will stop taking it if they are preparing the company for an IPO, for example.'

Fees on fees
The fact that firms charge their portfolio companies for their services causes disquiet among some investors. Few would disagree with the concept of charging a transaction fee: buy-out deals are expensive to execute and the transaction fees usually cover the cost of broken deals or abort costs. But it is possible to argue that monitoring fees, for example, should not be charged by buy-out funds. It's only by working with a company and improving it that firms will make the returns they need for carried interest to kick in. It's part of their job to provide strategic and consulting advice to companies, after all. ‘Charging monitoring fees is not done by the majority, but it is becoming more common,' says Hamilton Lane's Erik Hirsch. ‘Our preference is that GPs do not levy additional fees on their portfolio companies. We would like that cash to stay within the company so that we can all share in the profits when the company is sold.' HarbourVest's George Anson agrees. ‘If you are chipping away two to three per cent from a company every year, that is going to have an impact on the overall outcome,' he says. ‘In an ideal world, we would rather see that accruing to the capital gains than in income as we go along.'

And yet it is not the amount of money that buy-out firms charge their portfolio companies that most concerns limited partners. It's what they do with it. If firms are pocketing all the fees they charge to their portfolio companies, investors argue, then the basic tenet of alignment of interest between general and limited partners is being skewed.

‘The concern from the LP side is that the more GPs become reliant on management fees, transaction fees, monitoring fees, etc, the less they are reliant on carried interest,' explains Hirsch. ‘As an LP we want fund managers to be incentivised by carried interest and nothing else. Otherwise, it's perfectly possible for fees to become so large that funds can be profitable without creating profitable transactions. If that happens there is a clear lack of alignment of interest between LPs and GPs.' It's a sentiment shared by Marc der Kinderen of 747 Capital. ‘GPs' interests should be 100 per cent aligned with those of the LPs. If fund managers want to be in the business of making fees, they should be in investment banking, not private equity.'

So what do fund managers do with it? The answer is not straightforward. Different funds treat this income in different ways and often LPs are unable to track exactly what a firm is charging its portfolio companies. Some firms will offset some or all of the fees they receive against the management fee; others won't.

A report produced by US law firm Debevoise & Plimpton in 2001 provides some insight into common practice. Its survey of 402 buy-out and venture capital funds examined the level to which they offset the fees they received against the management fee. It found that over 80 per cent of the funds included in the sample returned 50 per cent or more of directors' fees, transaction fees or income other than monitoring fees through management fee offsets. It also found four main groupings for each of these types of fee. The majority returned 50 per cent, followed by another grouping, which returned 100 per cent. The next most popular value was zero (ie, none of the fees were returned) and the last main grouping was 80 per cent being offset against the management fee.

But the survey also identified an interesting trend - one that reflects LPs' growing concerns about the treatment of ‘other' fees. It found that the more recent funds were most likely to have higher offset percentages than those established in the early 1990s. The survey puts this down to the fact that ‘institutional investors have become more sophisticated and insistent in asking for them'.

It's a trend that is likely to have accelerated since the survey was conducted in 2001. As fundraising has become tougher, so GPs have been more willing to concede on distribution of fee income. ‘In every single fund commitment we have made over the last two years, we have seen some movement in our favour in the way that fees are treated,' says Anson. ‘We have seen funds shift from sharing fees 50/50 to 80/20 or from 80/20 to 100 per cent going to the fund.'

Fair compensation
Despite the fact that the trend is going against them, many GPs still argue that they should retain at least some of the fees they generate. Take directors' fees. Some firms believe that at least part of these should be paid to the individual sitting on the company board to compensate them for the risks inherent in the position and for the responsibilities they have taken on compared to the other members of the team. Many claim that they provide valuable services to their portfolio companies that they would otherwise have to hire consultants and other professionals to do. If the firm keeps part of the fees, it provides managers with an incentive to do the work themselves and therefore become more hands-on with their companies. They also point to the fact that transaction fees are offset against the costs associated with deals that don't go through (although one fund manager said he felt any excess income derived from transaction fees should go towards paying the entire team bonuses).

Yet the problem with some of these points, investors counter-argue, is that income generated by fees can influence fund managers' behaviour. If a fund manager is able to keep some or all of the transaction fees, for example, there is a temptation to do deals for the sake of it. ‘Sharing of transaction fees really annoys me,' says Charles Froland of General Motors Investment Management Corporation. ‘LPs should get all of it rather than sharing it with GPs. Fund managers extract enough money through the management fees alone. Why should they take more from their portfolio companies? I think it gives managers the wrong incentives.'

‘I don't have a problem with managers being greedy at the back end of a transaction - that's how they are supposed to be incentivised,' says Anson. ‘But they shouldn't be greedy at the front end. If someone tells me that they are going to do a deal because they'll get a $3m transaction fee, that tells me they are prepared to pay any price to win the deal.' It's something he has seen first-hand. ‘I have been in a meeting at which the GP said they wanted to close a deal because they had racked up $750,000 in abort costs that year. What kind of a reason is that to do a deal?'

A point of principle
But keeping fees is a practice that many GPs have found increasingly hard to validate as their fund sizes have crept up and - importantly - as professional private equity investors, mainly in the form of funds of funds, have become a more powerful force in the market. ‘As a firm, our sole source of income is through the management fee on the funds we manage,' says Anson. ‘If we ever had occasion to charge any kind of fee the assets we manage, it would go straight back to the client. That's our philosophy and we believe the funds we commit to should be similarly minded. It's very tough for a firm to justify why, on top of a management fee, there should be another lot of supplementals going to the manager. Our view is that the only basis on which fund managers are able to generate those fees is because of those that provide their capital - us and other institutional investors. Therefore, the benefit that they derive should come to us.' Der Kinderen agrees: ‘I am very clear about this issue. For me, it's a matter of principle. These fees are simply part of the portfolio management package. The only reason firms are able to charge them is because we and other investors have committed to their fund. There should be a mechanism by which income can be distributed fairly between investors and fund managers.'

The question is what that mechanism should be. Der Kinderen believes that offsetting against the management fee may not be the fairest - or most motivating - way of treating this type of income. ‘If you manage a private equity firm, you are essentially an entrepreneur,' he says. ‘In that case, you should have current compensation that is fair, but you should also have substantial upside if things go well.' In his opinion, income should go directly back to the fund, rather than be offset. ‘If the legal documentation is structured properly and if things go well, the manager should get 20 per cent of the profit, including any of the fees generated. That way, everyone benefits if the investments work out well,' he explains. It's an approach that veers from ‘standard' practice, but it's one he feels works in investors' and fund managers' interests. The problem is that he finds the suggestion falls on deaf ears in the GP community. ‘These issues are generally not open to discussion,' he says. ‘The only chance you have to make it work is with next generation managers, who tend to be more flexible.'

But the fact that the newer entrants on the block are prepared to contemplate this type of arrangement means that we could see some shift in the ways in which fund managers treat fees charged to their portfolio companies. Some of these newer funds will be successful in the future and they are unlikely to be able to change their terms and conditions significantly in the subsequent funds. It's a point made by the Debevoise & Plimpton study, albeit on the subject of offsets rather than fund credits: ‘If a sponsor accepts 100 per cent offsets (for example) in Fund II, it will be very hard for the sponsor to take it off the table in subsequent funds, even if the investor who insisted on it in Fund II doesn't take part in subsequent funds.'

Room for manoeuvre
So it seems as though change in this area is gradually happening. And, as with most of these issues at the moment, it is the investors that are driving that change. All the LPs we spoke to said that any shifts in the treatment of fees had come as a result of a process of negotiation with GPs. Again, the Debevoise & Plimpton study backs this up. It says: ‘These data as well as anecdotal evidence from our practice suggest that the key driver of the level of management fee offsets is whether the sponsor has encountered a major investor that absolutely insists on larger offsets.' Evidence once again that it's incumbent on investors to ensure that GPs' interests are totally aligned with their own. But evidence, too, that a little pressure exerted in the right places can yield results.

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