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.