Private Equity Portfolio Company Fees
University of Oxford – Said Business School
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University of Oxford – Said Business School
Marc P. Umber
Frankfurt School of Finance & Management
November 25, 2015
A less known fact about private equity is that General Partners (GPs) enter ‘service agreements’ specifying fee payments by companies whose boards they control. 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. Fees do not vary according to business cycles, company characteristics, or GP performance. Fees vary significantly across GPs and are persistent within GPs. Once these fees became public information GPs charging the least to companies raised significantly more capital. GPs that went public distinctively increased their fees. We discuss how results can be explained by optimal contracting versus tunneling theories.
Private Equity Portfolio Company Fees – Introduction
“It is not clear exactly what these transaction fees are paying for, since GPs should already be receiving (…) management fees. We think of these transaction fees as just being one way that [GPs] can earn revenue (…) It is difficult to find reliable information about the frequency and size of these fees (…) As with transaction fees, we think of monitoring fees as just another way for funds to earn a revenue stream.” Metrick and Yasuda (2010)
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. Google Trend shows no searches prior to November 2009 for private equity portfolio company fees and a steady flow of related searches thereafter. 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. In August 2015 one of the largest private equity investors said that it will no longer invest in funds that do not disclose all of their fees.1 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 so called accelerated monitoring fee issues.
Relatively little is known about private equity portfolio company fees: What are the different types of fees, what do they pay for, how much is charged? How common are the accelerated monitoring fees the SEC seems to focus on, are these fees a new phenomenon? Do fees vary by GP, business cycles, or company type? Can these fees be rationalized? Using acomprehensive hand collected dataset, this paper aims to fill this gap.
Most private equity funds are organized as limited partnerships, with private equity firms (e.g. Blackstone, KKR) serving as general partners (GPs) of the funds, and institutional investors providing most of the capital as limited partners (LPs). Limited Partnership Agreements (LPAs) are signed at the funds’ inceptions and define the expected payments by LPs to GPs: a fixed management fee, a carried interest which is paid if a certain return is achieved (like a call option), and the fraction of portfolio company fees that is rebated to the LPs. Gompers and Lerner (1999) and Metrick and Yasuda (2010) show that these fees are overall similar across GPs and over time.
When GPs find a suitable investment, they call the necessary amount of capital from LPs, arrange the acquisition, and join the board of directors, which in turn appoints the Executive team. We find that in most cases a Management Services Agreement (MSA) is signed between GPs and the Executive team acting on behalf of the company. MSAs list various portfolio company fees and the services they are associated with. Our analysis of these MSAs shows that these fees are ex-post discretionary compensation items for GPs.
As most limited partnerships last for 10 to 14 years, LPAs are necessarily incomplete contracts. It is not only costly to write the numerous contingencies that can arise over such a long period of time but also difficult to even foresee these contingencies. For example, five years after the LPA is signed a financial crisis may trigger a hike in the cost of executing or monitoring LBOs. The earliest foundations of transaction cost economics (Williamson (1971)) argue that incomplete contracts imply the need for ex-post adaptation. The procurement literature, for example, highlights the importance of allowing agents to charge ex-post adaptation costs (e.g. Crocker and Reynolds (1993), Bajari and Tadelis (2001), Bajari, Houghton, and Tadelis (2014)). The solution to the dynamic incomplete contracting problem in the private equity industry may be similar to that of the procurement literature. We need a combination of an ex-ante contract such as the LPA, which is standard and similar across GPs, followed by an ex-post adjustment contract such as the MSA. A similar justification is that MSAs smooth out GPs’ compensation and therefore reduce GPs required risk premium, hence enables LPs to reduce the average compensation of GPs (see, e.g. Itoh (1993) and Holstrom and Milgrom (1990)).
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