Tuesday, December 3, 2013

Blowing the Whistle on PE Fees: I Don’t Think So

Blowing the Whistle on PE Fees: I Don’t Think So

Those of you who have read this blog for a while know that I am a critic of the additional fees imposed by private equity firms.  In addition to the 1.5% or 2% management fee, many firms charge their investors fees for structuring transactions and monitoring portfolio companies.  It is my view that the management fee should cover the cost and effort of these activities.  According to Crain’s New York Business, an unnamed whistle-blower has brought a complaint to the Securities and Exchange Commission about these practices.[1]
Cross Sell (1999)
Although I believe transaction and monitoring fees are unwarranted, I am having a hard time thinking of anything illegal about the practice.  Investors enter into detailed agreements with private equity firms that explicitly allow funds to be debited for these services.  Investors don’t like these additional charges, but they only manage to negotiate them down in weak markets.  Unless there’s something funky in the way PE firms are calculating transaction or monitoring fees, I am not sure what the SEC can investigate.

To be sure, the dollars generated by these add-ons are significant.  For example, in the first nine months of 2013, KKR generated $93 million in monitoring and transactions fees on top of $340 million in management fees, or 21% of its fees from its private market activities (see below).[2]  Blackstone had $79 million in additional fees, or 22% of its total fees.[3]

Did you notice in the data that KKR credits a portion of the monitoring and transaction fees back to its investors ($97.2 million)?  There’s a game being played between the PE firm and its investors.  Rather than eliminate or reduce these fees, PE firms routinely offer to credit some portion of the fee back to the investors.  Very often the figure is 50%.  In other words, investor are supposed to feel better about only paying half of what that they shouldn’t have paid anything for. 

You can understand why PE firms love these fees.  Obviously, add-on fees are almost entirely financial windfalls to private equity because the management fee more than compensates the firm for these activities.  Better yet, transaction and monitoring fees provide PE firms with a handy way of recouping some of their investment in deals that don’t work out.  Even if a deal is a total bust, the PE firm can garner millions in fees while their investors get crushed.

All of this is pretty ugly, but ugly doesn’t necessarily mean illegal.

[1] http://www.crainsnewyork.com/article/20131201/FINANCE/312019969
[2] KKR 3rd Quarter Form 10-Q 2013, page 43.
[3] Blackstone 3rd Quarter Form 10-Q 2013, page 80.

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