Private Equity Portfolio Company Fees

Ludovic Phalippou is an Associate Professor of Finance at Saïd Business School, University of Oxford. This post is based on an article authored by Professor Phalippou; Christian Rauch, Barclays Career Development Fellow in Entrepreneurial Finance at Saïd Business School, University of Oxford; and Marc Umber, Assistant Professor of Corporate Finance at Frankfurt School of Finance & Management.

When private equity firms sponsor a takeover, they may charge fees to the target company while some of the firm’s partners sit on the company’s board of directors. In the wake of the global financial crisis, such potential for conflicts of interest became a public policy focus. On July 21st 2015, thirteen state and city treasurers wrote to the SEC to ask for private equity firms to reveal all of the fees that they charge investors. The SEC announced on October 7th 2015, that it “will continue taking action against advisers that do not adequately disclose their fees and expenses” following a settlement by Blackstone for $39 million over accelerated monitoring fees.

We show that it is possible to obtain comprehensive information about the portfolio company fees charged between 1995 and 2014: we examine 25,000 pages of relevant SEC filings covering 1,044 GP investments in 592 Leverage Buy-Out transactions, whose total enterprise value, including add-on acquisitions, sum up to $1.1 trillion.

The sum of the transaction fees in our sample is $10 billion, and monitoring fees sum to a similar amount. Other fees (e.g. refinancing fees) add up to $2.4 billion. In total, these portfolio company fees add up to nearly $20 billion, representing 6% of equity invested, and are basically equally distributed over time. These fees do not cover the cost of doing business as these costs are refunded separately by portfolio companies; they are ex-post discretionary fees paid irrespective of work effectively carried out.

Such ex-post adaptation fees may be optimal. For example, targeted companies may become unexpectedly riskier or more difficult to acquire and monitor. Empirically, however, we do not find any relation between fee levels and any such company characteristics or credit cycles. We find similarly little supporting evidence for other “optimal” arguments.

Alternatively, these fees may be a wealth transfer. As with any wealth transfer, a stakeholder must lose out and we identify three possible victims. First, the transfer may be at the expense of the tax authorities. Fund managers transfer cash out of the company and call it a fee rather than a dividend because fees, unlike dividends, are deductible from corporate taxes. Managers then share the tax savings with investors. However, although most companies pay fees only half of the companies pay corporate taxes. Also, fees are unrelated to the amount of earnings before tax, hence to potential tax savings. Finally, the fraction rebated to investors is often less than one minus marginal corporate tax rate.

Second, the transfer could target investor supervisors: e.g. regulators, the board of trustees. Investors report to their principals the fees that they pay to the Managers. By charging fees directly to portfolio companies instead of charging management fees to investors, expense ratios reported by investors to their supervisors are lower. Under this view, investors should reward fund managers with higher fees. However, we find that once the existence of these fees became public information, high-fee managers raised little to no capital going forward. In contrast, low-fee managers have all raised a new fund, in a relatively short time, and most of them have raised more money post-crisis than pre-crisis.

Third, these fees may simply be a transfer of resources out of a company to its controlling shareholder via self-dealing transactions. This is similar to the tunneling situations explored in the literature but there is an important difference here: the GP-LP interaction is a repeated game. If Managers divert cash away from Investors, returns are lower, hence future funds are smaller, and future fees are lower. In addition, Investors may notice this and drive tunneling Managers out of business. Under this view, manager horizons should play an important role.

To test this view, we study the change in fees around the decision by three fund managers to sell part of their own company. If portfolio company fees are manipulable and depend on manager horizon, we would expect fees to increase for the selling managers. Moreover, we expect monitoring fees to increase more than transaction fees because the former, unlike the latter, is recurring over time. We find that the three selling managers nearly doubled their monitoring fees while the other three comparable managers decreased their fees. For transaction fees the difference is less pronounced indeed.

Overall, the body of evidence is difficult to reconcile with the “optimal” view or the “tax” view. Managers that charge the highest fees tend to be outliers, small, young, and raise significantly less capital going forward. Market forces seem at work although they seem to have taken two decades to manifest themselves. Perhaps the regulatory intervention has been decisive in helping out investors who have not generally benefitted from SEC protection. We note however that the magnitudes of the SEC fines so far are not commensurate with the amount of fees we document here and that managers that have been fined are not those charging the most. Also, expenses charged by managers to portfolio companies may present the largest potential for conflicts of interest. We do not have data to analyze expenses or potential kickback arrangements but it would be a natural follow up study.

The full paper is available for download here.

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