Friday Letter: Nickel and dimed

Private equity’s hidden fees are becoming less hidden

If you listen to general partners, negotiating a limited partnership agreement can sound as complex and protracted as the Yalta Conference. Fundraisers will point you to pages upon pages of questionnaires, endless email threads, phone calls after phone calls, and documents galore. The larger the fund and the number of investors, the more protracted the process. Now, with LPs feeling emboldened, their push-back on charges that used to be difficult to spot is getting stronger.

Propelling this trend are the regulators, such as the Securities and Exchange Commission (SEC), who are taking a closer look at LPAs, management company operations, and the overall inner workings of the industry. They’re shining lights on certain fee arrangements that hitherto were not transparent, and as they do so, evidence is also emerging of GPs responding to the scrutiny by changing their fee arrangements and disclosure practices. According to sources, what we’re seeing could well be the beginnings of a new era for fund economics in private equity, in which LPs will force greater transparency, the elimination of certain fund investment costs entirely, and more wide-ranging use of offset arrangements for other kinds of fee that will remain.

Offsets are nothing new in private equity, but recent reports featuring the likes of Blackstone and TPG have served as a reminder that certain types of ancillary charges for GP services at the portfolio level such as healthcare consulting or bulk purchasing still exist without any offset. In response to the SEC looking into Blackstone’s and TGP’s fee charging, both firms recently altered their marketing documents to provide fuller disclosure. Another manager, Los Angeles-based Freeman Spogli, has gone as far as bringing in an independent evaluator to monitor expenses for its latest fund, at the behest of a warning from the SEC.

Unsurprisingly, advocates of investor interests are hailing these developments as a positive for LPs, even while noting it has been slow going to get to this point. The GPs we spoke to are being philosophical. They note that increased scrutiny, coupled with a dip in performance following the financial crisis, was always going to bring pressure to rewrite the book on costs and disclosure.

As a result, LPs can now expect a clearer picture emerging on costs which previously may have been shrouded in unhelpfully vague language in the LPA. And while some GPs will grumble about having to fight over every dime they can charge going forward, there’s no getting away from the fact that greater standardisation on fees and disclosure will be a net positive for the industry. For the longest time, investors in the asset class have been wanting to see straightforward arrangements, be able to work out the difference between gross and net performance easily, and make reliable like-for-like comparisons between the funds in their portfolios. At long last, it looks like they’re finally going to get these things.