Throughout the recent controversy over fees and transparency – sparked by the SEC’s comments about the extent of malpractice at newly-registered GPs, and fanned by subsequent stories about how particular managers have been taking liberties – the prevailing narrative has been that credulous LPs are being unwittingly taken advantage of by their much smarter GPs. Their “pockets are being picked”, as one unnamed SEC official apparently told the New York Times recently.
Now it's clearly true that lots of LPs have, over time, accumulated more GP relationships than they can easily manage, especially in this era of greater disclosure. And in some cases, they're trying to manage these relationships with a relatively skeleton staff. In such circumstances, the level of GP scrutiny – the extent to which LPs are able to 'sweat the small things’ – will inevitably diminish. And the sheer complexity of these agreements inevitably makes it easier for abuses to pass unnoticed; it's not easy to itemise all the possible supplementary fees and expenses that may crop up over the course of the fund (from admin costs, to consulting expenses, to monitoring and transactions costs, etc.), which means a degree of trust is typically involved.
So it’s perfectly possible that some LPs are (at least in danger of?) being exploited. And in instances where this is proved to be the case, GPs deserve everything they get. But does this narrative ring true more broadly? We're not convinced.
Maybe there was a time when most LPs were sufficiently inexperienced and/ or credulous to sign pretty much anything that would get them into the top funds. But these days – particularly since the financial crisis, and particularly since the emergence of ILPA – the majority are much smarter and more sophisticated in the way they negotiate their LPAs.
GPs – even the top-performers – will tell you that getting a fund commitment these days is a far more time-consuming and labour-intensive process than it has ever been. LPs spend more time, ask more questions, talk to more people. Their due diligence covers the operation of the back office as well as the track record of the investment team.
What's more, these supplementary fees have been a specific focus of this extra scrutiny – to the extent that an offset of other fees against the management fee of at least 80 percent and often 100 percent has, over the last few years, become the industry norm. Which raises an important point: a GP usually can't get into carry – which is the way they really make money – until they've reimbursed all fees (plus the preferred return on top).
Investors have been heavily criticised for not kicking up enough of a fuss about fees. But actually, a lot of them have been negotiating hard on this specific point in the last few years. In many cases, they've decided they're comfortable with today's fee arrangements because a) they'll get them back anyway if the fund performs and b) it's a relatively tiny element of the fund's economics (and a drop in the ocean compared to the management fee, which is a whole other issue).
It’s also worth remembering that this is a 'heavily lawyered' industry. LPAs are scrutinised in great detail by highly-paid attorneys whose job is to get the best deal for their client. Maybe you could argue (and people have) that all these lawyers are collectively either institutionally incompetent or turning a blind eye to malpractice, perhaps because they don't want to bite another of the hands that feed them. But does that not feel like a conspiracy theory too far?
So is this a case of “move along, nothing to see here”? Not necessarily.
This week Naked Capitalism, a financial blog, published 12 LPAs that had been accidentally made available online by a state pension fund, along with an admirably thorough analysis of some of the more debatable terms therein. There weren’t really any smoking guns – in fact, as NC itself pointed out, the LPA’s very blandness and uniformity makes it hard to see why they need to be quite so confidential. But the vituperative response from people outside private equity highlighted once again how eager people are to believe the worst about it.
And to some extent, the industry only has itself to blame. If you act like you have something to hide (as per the insistence on treating LPAs as trade secrets) people will assume that you have. Equally, the idea of a multi-billion dollar fund with a nine-figure management fee charging relatively tiny additional expenses to its LPs (even if you later reimburse them) seems self-defeating, to say the least – it presumably won’t make much difference to the economics, the optics are terrible, and it provides a precedent that the few bad apples can take advantage of.
GPs might argue that as long as investors don’t mind this stuff, it doesn’t matter what the rest of the world thinks. But it’s naïve to think the general perception of private equity won’t ultimately have an impact, either through regulation or the allocations of public pensions. Managers need to start working on the basis that every LPA they sign may end up in the public domain – and if that means adjusting their approach with a view to the way things might look, so much the better for all concerned.