Withum Sounding Board

Podcast: Private Equity Fees and Expenses

Venture Capital

Podcast: Fees and Expenses in the Private Equity Industry

Peter Lubcker, Withum’s Financial Services Group Member, interviews Tom Angell, Partner and Leader of the Financial Services Group, on why private equity fees and expenses are such a hot topic in the financial services industry.

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Speaker 1:
[inaudible].

Speaker 2:
Thank you for joining us for this segment with them sounding board and practical audio based information for today’s on the go professional production Withum Smith & Brown PC.

Speaker 3:
Hi, I’m Pete leper, senior manager wouldn’t Smith and Brown in our private equity practice today. I’m here with Tom angel, partner Withum Smith and Brown and head of the product we practice. So you going to be talking about fees and expenses in the private equity industry. So Tom, how are you today? Good Pete. Glad to be here. So Tom, why are fees and expenses such a hot topic in the private equity industry? Well, Pete had actually started back in 2010 when investment advisors with over $150 million in regulatory assets under management were required to register with the sec. The sec then began what they called presence exams and October of 2012 and they were meant to establish a presence in the private equity industry. This was a period where the sec was trying to get an understanding of how the private equity industry operated and to assess the issues and risks that the private industry had within the general economy.

Speaker 3:
So what was the result of these presence exams? Well, there were a few items that the sec found concerning the two main items were fees and expenses and valuations. So we’re just going to talk about fees and expenses today. And the results of the president’s exams actually led to enforcement actions. The first enforcement action was brought in February of 2014 against the firm called clean energy capital. They had charged that clean energy allocated various payroll expenses to the fund instead of the management company. There’ve been several other highly publicized cases of fee and expense charges over the last year or so. Prior to the registration, it was typical for advisors to collect fees and expenses from portfolio companies with offsets against the management fee is a 50% or less. In fact, there was a little transparency to the investors over time as LPs became more aware of the fees being collected for the portfolio companies.

Speaker 3:
The management fee offsets have increased to the point where most funds now have between 80% to a hundred percent offset against the management fees. I see. What types of expenses and fees are we talking about? Well, there’s a wide range of fees and expenses that have been looked at by the sec as well as how these expenses are allocated between the fund management company and the portfolio company and also potential co-investments, many of the limited partnership agreements or broaden their characterization on the types of fees and expenses that can be charged portfolio companies and gives the GP a lot of latitude and its application such items as broken deal fees, monitoring fees, advisor fees, payroll and benefits have all come under scrutiny and what are the issues? Issues aren’t just the expenses themselves but how they are structured and allocated. The biggest issue found by the sec is a lack of disclosure of the investment advisors practice and the potential conflicts of interest and the expense charges.

Speaker 3:
And back in may of 2014 and a speech given by Andrew Bowden who was director of compliance inspections and examinations at the time said that regard to expenses, half the funds that were looked at in the presence exams either had perceived violations of law or material weaknesses and controls. So let me give you some examples of the types of concerns the sec expressed. Consultants or operating partners as they are known in the industry are typically charged to the fund or portfolio company. Operating partners are used to generate value through operational improvements. The concern with the SCC is that these operating partners are marketed to LPs as part of the adviser to enhance the expertise of the investment manager. The investment manager is deriving this benefit even though the fund or portfolio companies paying the fees. In addition, the fees the operating partners receive are rarely used as offsets to management fees.

Speaker 3:
As discussed before, there’s virtually no transparency on this issue. Another item of concern was accelerated monitoring fees. So monitoring fees are charged to portfolio companies by advisors for such things as board seats or other advisory services. The advisor has caused some of its portfolio companies to sign longterm monitoring agreements and these agreements could be for more than 10 years even though the typical before legal holding period is five years upon a liquidating event such as a sale or an IPO. The remaining term of the contract is a seller rate. It does benefiting the advisor with additional funds. Again, little disclosure to the LPs in this area. One other example is related party service providers and their conflicts at that brings the advisor could dictate the terms of hiring the related party. The sec has questioned the value provided to the portfolio companies from the related party advisors.

Speaker 3:
I see and what is being done in the industry to correct this perceived problem. Many funds that have reviewed the issues brought to light by the sec and its presence was AMS and have taken corrective measures and how they are actually handling fees and expenses and also how they are allocating those expenses between the management company funds and portfolio companies. Some of the fines on the high profile cases were not as severe as they could have been because the advisors had started remedial action on the issues prior to the SCCs presidents exams, so they had taken a look back and realize that there was a problem and decided that let’s correct this and when the FCC came in and I said, okay, they’re already working towards this, so the fines will be less and new funds. The LPAs are being written with more specific language as to how fees and expenses will be handled as well as giving more overall transparency to the investors.

Speaker 3:
Okay. Recently the ILPA, the institutional limited partners association released a fee reporting template to try to capture all the expenses and fees charged by the advisor and how they are to be applicated. How has this been received? Well, the template is meant to improve transparency and bring our global reporting standards to the industry. The template is detailed as the type and amount of fees charged to the portfolio companies. It also details the fees charged the funds, LPs. There was also a section that shows the percentage of management fee offsets as well as the amount for each of the previously discussed expenses. The template itself has gotten the backing of some of the industry’s biggest players. The issue right now is that the ILPA is made up of only 320 LPs. Granted they are the largest investors in the world, but it leaves out many LPs that are not part of the ILPA and I’ve not had the chance to comment on the template and maybe difficult process to get this particular template to be a global standard and interesting.

Speaker 3:
The question would be how funds are dealing with this issue currently and what their plans are in the future with them. Smith and Brown is one of the sponsors of a survey being performed by private fund manager, title PFM fees and expenses survey 2016 this should give us some insight in how funds are reacting to the, Adam’s brought up by the sec. The results of the surveys should be out sometime in September of 2016 and we’ll probably have another podcast. Thank you, Tom. That was very informative. Are there any websites you suggest to obtain more information? You want you to go to the ILP, a website just to see one of the list of the fees and expenses are, and there’s a discussion within their website talking about the various issues that have come about and what they’re trying to remediate in terms of more transparency to the LPs and a more detailed schedule. So everybody’s on the same page when they’re looking at documents from general partners. Thank you for your time today, huh? Thank you, Pete.

Speaker 2:
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