Partial Tally of Hidden Private Equity Fees: 6% of Equity Invested

A study just released by Oxford Professor Ludovic Phalippou seeks to identify how much limited partner are paying in fees they don’t see and can’t control, as in the charges private equity firms make to the companies they buy on behalf of investors, the so-called “portfolio companies”. The headlines at the Wall Street Journal and the Financial Times report his study as finding $20 billion in hidden fees, but they fail to emphasize that this study was based on an in-depth examination of 592 companies and 1044 transactions, meaning a subset.

Remarkably, neither article includes a conclusion in the study’s’ opening paragraph, which is far more arresting (emphasis ours):

We describe these contracts and find that related fee payments sum up to $20 billion evenly distributed over twenty years, representing over 6% of the equity invested by GPs on behalf of their investors.

We’ve embedded the study at the end of the post. It has lots of juicy detail and data tables, so we may have more to say about it once we’ve had time to read it closely.

The reason these fees have been opaque to investors is that they are not paid by the private equity fund, but skip the fund’s books entirely by going straight from the investee companies to the general partner. And the arrangements are not set forth in the limited partnership agreements that govern these deals either. Yes, the limited partnership agreements give the general partners the right to make enter into these types of contracts with the portfolio companies, peculiarly without setting any parameters on them. One type of common agreement, so so-called monitoring agreement, routinely calls for companies to pay fees whether any services have been rendered or not. As Phalippou has “translated” these agreements for the benefit of his students:

I may do some work from time to time
I do some work, only if I feel like it. Subjective translation: I won’t do anything.
I’ll get [in this case] at least $30 million a year irrespective of how much I decide to work. Subjective translation: I won’t do anything and get $30 million a year for it.
If I do decide to do something, I’ll charge you extra
I can stop charing when I get out (or not), but if I do I get all the money I was supposed to receive from that point up until 2018.

This study does represent a meaningful sample. The 592 companies represent a total of $1.1 trillion in value. The fees charged over twenty years was $16 billion; adjusted for inflation, the total comes to $20 billion. And these companies generally were larger than average by virtue of having been reported in SEC filings. But these 592 companies stand in contrast with the roughly 865 funds in which CalPERS has invested from the inception of its private equity program in 1990 through last October.

Also bear in mind that this study does not capture all fees and expenses. For instance, it omitted refinancing fees ($2.4 billion alone for these companies), director fees, break-up fees, kick-backs from portfolio companies, and private jet charges.

One of the important finding is how variable the charges are, both by company and over time. For instance, three general partners who were going public doubled their monitoring fees (which investors in their stocks would value because they would see those charges as recurring), while three similar general partners that stayed private decreased their monitoring fees by 38% over the same time period.

The study suggested that limited partners did “punish” the greediest general partners:

If we simply rank GPs by the amount of fees they charge, we see that about half of those
charging the most have not raised a new fund since the crisis. Most of the others have raised much
smaller funds. In contrast, the GPs that charge the least have all raised a new fund, in a relatively
short time, and most of them have raised more money post-crisis than pre-crisis.

But I wonder if the causality is backwards, that these general partners knew they’d have trouble raising their next fund, because performance was lousy or because some key members of the team left to start a new fund, and the general partners decided their best course of action was to milk their current funds for as much in fees as possible. The SEC has called out this type of conduct in “zombie” funds.

Moreover, some companies paid no fees; some paid massive charges, as much as more than 10% of EDIBTA or more than 5% of total enterprise value. The study point out that the biggest general partners were not the worst actors and calls out the SEC for failing to pursue them:

This indicates that the SEC has not focused on GPs that charged extreme fees, but instead seems to have focused on ‘famous’ GPs…. the magnitudes of the SEC fines so far are not commensurate with the amount of fees we document here and that GPs that have been fined are not those charging the most. Also, expenses charged by GPs to portfolio companies may present the largest potential for conflicts of interest.

Needless to say, the report also points out that these charges are rebated in part against management fees. But as Phalippou stressed to the Financial Times:

Private equity managers often pay some of these hidden fees back to investors via reductions in annual management fees, but Mr Phalippou believes the reductions could go further. “The official expense ratio reported by investors can be significantly understated,” he said.

While the two news stories flagged other important details. For instance, the Journal did point out that general partners could and did rip out large fees on deals that cratered:

Fees were earned even when deals failed. The $32 billion takeover of Texas-based utility Energy Future Holdings Corp. entered bankruptcy protection in 2014. Even so, the deal earned $666 million of portfolio company fees for KKR & Co., TPG and Goldman Sachs Group Inc., the report said.

Both the Journal and the Financial Times mentioned a “back of the envelope” calculation using CalPERS data to give a sense of the magnitude of these only partial “hidden fees” compared to carry fees. From the Financial Times:

Mr Phalippou’s analysis indicated that Calpers paid around $2.6bn in hidden fees on private equity investments made between 1991 and 2014 on top of its $3.4bn bill for carried interest. Around $1.3bn was repaid to Calpers as rebates against annual management fees.

Needless to say, this study underscores the importance of full transparency of fees and costs, as California John Chiang has called for in a proposal for legislation. This study will perform the important function of making sure the language of his bill is not watered down so as to allow the charges that Phalippou and his co-authors have identified to be omitted.

Private Equity Portfolio Company Fees

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  1. TheCatSaid

    Another kind of charge by GPs to portfolio companies I haven’t yet seen mentioned is recruiting fees–i.e., if the GPs determine a portfolio companies need to hire a key person, then they “help” recruit someone (or parachute in their BFF) and charge onerous recruiting fees (e.g., same amount as the new executive’s salary for one or two years, or a percentage).

    Thanks for mentioning the hefty fees that can be charged even if a specific deal doesn’t conclude. In the proposed contracts I’ve seen the terms were extremely vague as to when it would be applied. (The portfolio company could be led to believe that such an event would be unlikely, whereas to GPs they amount to a ring fenced-heads I win, tails you lose.)

    Thanks for repeating the info about management fees for “management” or “monitoring” that mention no deliverables or specific work to be done. This too is language I’ve seen, and when I asked for details was given only the most vague of a response.

    What’s needed might be an industry-wide adoption of standards that requires transparency of ALL feeds or charges or “expenses” of any kind charged by GPs and/or firms/consultants they recommend to portfolio companies. This might require new kinds of contracts 1) between portfolio companies and GPs and 2) between GPs and LPs.

    Maybe before investing LPs could require GPs to get a waiver of secrecy from all the portfolio companies in a fund, to allow true due diligence to be done by the LPs. Unless something like this occurs, LPs will NEVER have any way of truly doing due diligence. GPs will always be in a more advantageous position than the LPs regarding the position of portfolio companies–the solidity of their IP, their true financial position, etc. If the GPs know more than the LPs then it’s not a fair (markets!) basis for LPs to make an INFORMED free-will decision about whether to invest or not, and to evaluate WHAT TERMS (fees!) would be fair under the circumstances, including risk evaluation.

    The way it is now, GPs can evaluate risks about their portfolio companies but LPs have no way of doing so either before or after they invest.

    It’s a completely rigged game under the current conventional “rules” of non-disclosure.

    Pension funds should refuse to play until the rules of the game are balanced–not partly, not improved, not better than now, but full parity regarding access to information of all portfolio companies.

    Otherwise it’s just a blind investment based on a wing and a prayer with lots of wishful thinking–like buying a lottery ticket but the GPs are currently allowed to misstate and mislead regarding the odds.

  2. cnchal

    The Pirate Equity game, nicely explained.

    LPs commit capital to GPs and GPs are given five years to find suitable investments to
    spend that committed capital. When GPs find a suitable investment, they call the necessary amount
    of capital from the LPs, arrange the acquisition, and usually take control of the board of directors, i.e. assign the majority of the seats to their employees. . .

    . . . The board of directors, in turn, appoints the executive
    . A Management Services Agreement (MSA) is then signed between GPs and the Executive team.

    Let the looting begin!

  3. Fagui Curtain

    One of my few prides as an ex-banker is to always have refused to invest in private equity that I considered as a ripoff.
    At the time the standard fee structure was 5% per year and locked for 5 to 7 years. You’re giving the guy 35% upfront !! And you’re not even counting hidden fees everywhere. No wonder they give you sales call everyday, come with mini skirt ladies and want to offer you dinners at 3 star restaurants…
    They are far far worse than hedgies.

    1. Yves Smith Post author

      I have been too busy to debunk it. You can find two good takedowns in case I don’t get around to it:

      Professor Victor Fleischer added via e-mail:

      To put it another way: PE has performed well because it’s a leveraged equity investment.

      Suppose that a typical PE investment has a debt/equity ratio of 1:1.

      Let’s do the same for Calpers stock market portfolio. Suppose that 20 years ago, instead of allocating $x to PE, it allocated $2x to a low fee index fund, using $x in cash and $x in borrowed funds. The leveraged index fund would have greatly outperformed PE.

  4. Todd

    “Let’s do the same for Calpers stock market portfolio. Suppose that 20 years ago, instead of allocating $x to PE, it allocated $2x to a low fee index fund, using $x in cash and $x in borrowed funds. The leveraged index fund would have greatly outperformed PE. Exactly!
    If I recall correctly, when KKR went public, they were showing an “IRR” of 26,over 30 years based on the profit number KKR gave, no way that was correct.
    NO WAY!!!!!!!!!!!

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