Thursday, October 9, 2014

Small Positive Steps in Private Equity

Small Positive Steps in Private Equity

Over the last few days, The Wall Street Journal has been the source of two modestly positive stories about private equity from an investor perspective.  First, Blackstone has agreed to end the practice of charging a termination fee when one of its monitoring contracts is prematurely terminated by an IPO or the sale of a portfolio company.[1]  Second, the SEC is taking a close look at how consultants are paid for providing services to private equity firms and their portfolio companies.[2]

Two weeks ago in the News & Observer[3], I wrote about the termination fee being extracted by KKR from PRA Health Sciences.  The sum comes to tens of millions of dollars and is totally unwarranted.  In fact, it is hard to understand how the annual monitoring fee is justified in the first place.  KKR and other private equity firms are paid a management fee to buy and oversee portfolio companies.   They shouldn’t get paid twice.

According to The Journal, a couple of other large firms have promised to share the termination fee with their investors as an offset to the management fee.  While this may allay the concern of the private equity LPs, it doesn’t address the issue from the perspective of the new public shareholders.  Why should a newly public company have to part with $20 million or $30 million to satisfy a termination agreement that wasn’t negotiated at arm’s length?  There isn’t a good answer.

Let’s turn to consultants.  Private equity firms hire all sorts of consultants to advise on potential deals or portfolio companies.  Before I retired, I was one of those consultants.  What I didn’t know, and what investors seldom know, is who is paying for all those consultants.  One might expect that the PE manager is absorbing these expenses out of the management fee.  After all, the PE manager pays the salaries and bonuses of partners, associates, and analysts.  Why not consultants? 

The PE manager has a built-in conflict.  If consultants are paid out of the management fee, there’s less money for salaries and profits for the senior executives/owners of the PE firm.  Moreover, there are two ways of off-loading those expenses on investors.  The manager can charge the expense of consultants to the fund or a particular portfolio company.  As a result, the LPs absorb those expenses.  

This practice is particularly nettlesome when it comes to consultants who are considered operating partners.  An operating partner is usually a corporate executive who advises the PE firm on operational aspects of a particular business or sits on boards on behalf of the PE firm.  As far as the investor is concerned, these folks look like they work for the PE firm.  If you go to the firm’s website, operating partners are usually listed along side the partners and principals.  However, they aren’t on the payroll.  Again according to The Journal’s analysis, only about half of PE firms provide disclosure on this issue to their investors.  This is an area that is ripe for abuse and worthy of the SEC’s attention.

Having one major firm end the practice of termination fees is a tiny step in the right direction.  Hopefully, the SEC can shine some light on how private firms allocate costs, especially those of consultants.   However, we’d be making some real progress if the Internal Revenue Service entered the fray and starting taking a tough stance on the various tactics the private equity industry uses to drive down its tax bill.  Despite the recent news, big-time private equity continues to deliver the greatest value to its owners and senior executives. 


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