Friday, May 30, 2014

KKR’s Error Misses The Real Problem: Extra Fees

KKR’s Error Misses The Real Problem: Extra Fees

Any number of private equity and real estate funds have set up subsidiaries to provide services to their portfolio companies.  More than a dozen years ago, KKR set up an entity called Capstone.  The firm was designed to replicate the services provided by management consultants to KKR’s portfolio companies.  KKR probably thought it was a nice way to make a little bit of money and control their consultants.   Since Capstone doesn’t represent a monitoring or investment banking fees, KKR figured that it didn’t have to share Capstone’s fees with its investors, which is something it had promised in its 2006 fund.   Unfortunately for KKR, a small collection of its partnership documents wound up being disclosed on the website of the Pennsylvania State Treasurer.  Ives Smith blogging on Naked Capitalism did an excellent job of digging through the partnership agreement and discovering the Capstone snafu.

KKR immediately began to distance itself from Capstone by claiming that Capstone isn’t an affiliate and therefore isn’t subject to any fee sharing arrangements.  It seems like there are all sorts of bits and pieces of evidence that Capstone is an affiliate and therefore subject to fee-sharing arrangements.[1]

Naked Capitalism’s analysis comes after the SEC’s charge that a large number of private equity firms aren’t properly disclosing fees and expenses to their investors.  As a result, we have the makings of a worthwhile news story.

I’m in favor of fully disclosing to LPs any and all fees collected by private equity firms from their portfolio companies.  However, I’ve always thought the fee-sharing arrangement is a scam.  First, it distracts LPs from asking the more important question: why are these fees being incurred at all?  LPs pay good money for GPs to source, monitor, and restructure portfolio companies.  I’ve never understood why there are additional charges, whether they are shared or not. 

Second, since the PE firms control both the portfolio company and professionals or affiliates providing services, they are fairly free to set whatever fee they’d like.  For example, if a PE firm is charging $2 million a year for monitoring fees and is pressured to share 50% of that fee with its investors, there’s little to prevent the firm from jacking up their fees in the future to offset some or all of the fee sharing arrangements.

The blogosphere is treating the KKR documents as if Edward Snowden unearthed this material.    There’s nothing atypical about KKR’s agreements.  There’s a trove of material sitting at as a result of SEANC’s public records request in North Carolina.  Most of the material hasn’t been read.  However, it’s a virtual encyclopedia on the legal arrangements between GPs and LPs, along with the GPs twisted logic when it comes to trying to hide from the public records law.  I’m sure there are more interesting tidbits in those materials.

I’m glad that bloggers and reporters are digging into private equity and hedge fund fee arrangements.  I’m thrilled that the SEC is rooting about in this matter.  Disclosure would be a good first step.  However, I’d really like the LPs to wake up and put an end to a lot of these fee arrangements.


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