Leaders of the fee world
The management fee now finds itself the subject of some hostility. Investors question whether this particular fee, as we know it today, is a valuable aspect of the partnership agreement. But if LPs are grumbling, it is mostly to themselves, finds David Snow.
The lowly management fee is suddenly a hot topic. Perhaps this is because, in an environment where many private equity funds are showing flat or negative returns, the standard 1.5 per cent per annum check to GPs now seems like a great deal of money.
During the roaring late-1990s, management fees did not get nearly as much attention. The real sore point was carried interest. As cash distributions came pouring in, some GPs saw justification to increase their cut of the profits for follow-on funds. Carry was pushed from 20 per cent up to 25 per cent, even 30 per cent. Investors obligingly wrung their hands and murmured about the spirit of partnership investing, but still piled into hot technology funds.
Carry is not such a big deal these days. In fact, many LPs would no doubt be happy to pay a little extra in carry if it were attached to some – any – distribution event. Instead, the expense they now notice is the one not attached to any investment success. Management fees are not based on performance, but rather levied based on capital committed, and, after the fund's investment period is over, on capital invested.
In theory, the management fee is designed to keep the lights on at a private equity firm so the partners can go about the business of investing in, growing, and then profitably exiting private companies. But it doesn't take a math whiz to figure out that, especially for larger private equity franchises, the management fees are paying for much more than just the lights. A 1.5 per cent annual fee on a $1bn fund is $15m – not a bad yearly take for a handful of GPs. (Venture capital funds often charge as much as 2.5 per cent). This fee typically covers administrative expenses, such as rent, salary and employee benefits.
Get rich, stay rich
But the many expenses the management fee does not cover are striking. In a standard US partnership agreement, LPs must reimburse GPs for “organisational fees” – expenses associated with the “acquisition and disposition of investments,” reports to investors, tax and other accounting services, insurance premiums, and all legal and litigation expenses.
“The management fee levels we see were appropriate to funds that were being raised in the 1980s, but not appropriate now”
This means if LPs wish to sue their fund managers, they must also pay for their defense. The one-two punch of management fees and organisational fees can be fairly depressing for investors if the fund in question is doing little new investing, has produced no exits and is focused on the expensive task of trying to keep portfolio companies out of bankruptcy. This scenario has led some investors to ask themselves, “what am I paying for?”
“The management fee levels we see were appropriate to funds that were being raised in the 1980s, but not appropriate now,” says an attorney who advises LPs on terms and conditions. “The early idea was that the fees would provide an amount of current income to the GP that would be sufficient to pay the office expenses and pay the living expenses of the GPs, but not make them rich.”
Carry, the attorney notes, is supposed to make the GP rich, and stand as a powerful incentive to perform. “But when you get 200 basis points on a billion-dollar fund, or even a $500m fund, you get rich whether or not you invest the money wisely.” GPs, perhaps, were too smart to build investment franchises that lived or died on a deal-by-deal basis. Like any institutional money manager, an important part of the business plan for major private equity firms is assets under management, which provide a predictable revenue flow – an attractive business attribute that buyout firms look for in their portfolio companies. As assets under management grow, so too do the management fees, creating an ideal business franchise for GPs, but, one might argue, not an ideal way for LPs to invest capital in privately held companies. After all, if a major private equity firm is already assured $100m in revenue, do the top decision makers there really have the incentive to walk the factory floors, kick the proverbial tires, stay up late staring at spreadsheets – in short, work like dogs with the hopes of making yet another fortune?
Investors are shy to force the debate
One advisor to LPs refers to the situation created by management fees as such: young, hungry GPs on their first fund, who have yet to build a lasting business and do not have much in the way of assets under management, control a “get-rich fund.” Established GPs with billions under management and a solid record of profitable exits behind them manage a “stay-rich fund.” Which would you rather invest with?, asks the advisor.
This is, of course, a simplification meant to illustrate a point. Novice GPs have certainly been known to make poor investments, while established GPs with good track records are just as likely to succeed time and time again. But in the absence of much success from anyone these days, LPs are beginning to question the level of fees they pay for non-performing funds.
Market observers are well aware of the spate of capital give-backs, as it were, in the venture capital industry. Top-shelf firms from Palo Alto to London have, in apparently magnanimous gestures, freed LPs from significant portions of their original capital commitments.
There are many causes for this phenomenon, but chief among them is the issue of management fees. All parties to the limited partnerships know that a large fund with nowhere to invest presents an unequal situation, with the GPs collecting huge annual management fees, and LPs seeing their capital chipped away year after year with no apparent reward in sight. The fund reductions have been aimed at reducing these management fees as well as shortening the investment cycle now that venture capital deal flow has slowed to a crawl.
How about a budget?
The thought of GPs growing wealthy simply by dint of having raised a fund has some LPs reimagining the management fee altogether. Some are rereading their copy of a report issued in 1996 by consulting firm William M. Mercer, which recommended “budgeted fees” in lieu of traditional management fees. The budgeted approach would require GPs to submit yearly itemised budgets to LPs, much as they do for “organisational fees,” so that investors would only pay for the actual costs of running the firm.
Not surprisingly, when the Mercer report first came out, it was met with shrugs by GPs. Even now, with fund performance down significantly, many investors are reluctant to advocate any changes to traditional fees. The attorney says that while many LPs, especially large institutions, are in good positions to negotiate for lower management fees, most do not. “My perception is that most institutional LPs are reluctant to try and discuss fees,” he says. “They're cowed. They don't want to get a reputation.”
Indeed, after the Mercer report was released in 1996, Sheryl Pressler, then the head of CalPERS' private equity program, held a meeting with the senior partners of one of the most respected US private equity firms demanding that they justify the firm's $130m in annual management fees. The result: The firm did not change its fee structure, and CalPERS had its invitation to invest in its forthcoming buyout fund torn up.
“Most institutional LPs are reluctant to discuss fees. They're cowed. They don't want to get a reputation”
Not only do LPs not want to risk gaining a reputation for being quarrelsome, but portfolio managers, bless their hearts, often have ambitions of working on the sell side as a next career move, where, thanks in part to high fees, they can stand to draw a much larger salary.
For foes of superfluous management fees, the capital give-backs in the VC industry are an encouraging sign. The fact that a number of organisations such as the ILPA have vowed to push a number of issues including fees up the agenda is another. However, for private equity partnership investing to really undergo a transformation to fees that are based solely on performance, the LP community will need to act collectively – not a move they are well incentivised to make.
Deals & Exits
CSFB invests $750m in TXU Energy
In its largest investment ever, New York-based DLJ Merchant Banking, part of Credit Suisse First Boston's private equity arm, has invested $750m in retail energy producer and provider TXU Energy in the form of exchangeable subordinated notes due in 2012. The investment was made from the $5.4bn DLJ Merchant Banking Fund III, which closed in December 2001. The firm subsequently sold $250m of its stake to Berkshire Hathaway.
TXU Energy is the retail electricity provider and electricity producer of energy conglomerate TXU. TXU sold the notes as part of its effort to raise money to help its credit rating. The company will use the funds to help pay $20bn of debt. Berkshire Hathaway has increasingly become active in the private equity market. In August, the company bought publicly traded farm equipment manufacturer CTB International Corp from American Securities Capital Partners for a total of $58.65m. Berkshire Hathaway also recently completed a $2bn privatisation of carpet manufacturer Shaw Industries.
Two deals for Carlyle
Washington DC-based private equity firm The Carlyle Group has sold Entertainment Publications, a marketer of coupon books, discounts and merchant promotions, to new economy business conglomerate USA Interactive for approximately $370m. Carlyle was the lead investor in a 1999 buyout of the company, committing $47.8m in equity to the deal.
The firm also agreed to acquire a majority stake in ocean transport company CSX Lines from rail freight company CSX Corp in a transaction valued at $300m. CSX Lines, which owns 17 US flag vessels and 22,000 shipping containers, is the nation's largest ocean transport company.
Evercore backs $350m publishing buyout
New York-based private equity firm Evercore Partners, through portfolio company American Media, has acquired health and fitness specialist publisher Weider Publications in a $350m buyout. The group beat out Primedia chief executive officer William Reilly's Aurelian Communications, which had backing from Providence Equity Partners, VS&A Communication Partners, and private equity firm Nautic Partners. The magazines acquired include Muscle & Fitness, Flex, Shape, Fit Pregnancy and Natural Health, with a total readership in excess of 23m.
KKR, Trimaran pay $610m for Detroit Edison unit
Kohlberg Kravis Roberts has teamed up with New York-based Trimaran Capital Partners to acquire International Transmission, the transmission subsidiary of Detroit Edison parent company DTE Energy, for $610m. The grid serves 2.1m customers. DTE Industry sold the transmission business to focus on its core business of power generation and to reduce debt.
Welsh Carson invests in security, healthcare
Welsh, Carson, Anderson & Stowe, the New York-based private equity firm, has acquired Pennsylvania-based security services company US Investigations Services in a $981m deal. Welsh Carson is investing $380m from its Fund IX to fund the deal. The Carlyle Group, which acquired a 25 per cent stake in US Investigations in 1999 and later expanded that share to 30 per cent, is rolling over $122m in equity into the company. Services of US Investigations include background checks, drug and alcohol testing, and security for governments and corporations.
Welsh Carson has also taken private AmeriPath, a provider of cancer diagnostics, genomic, and related information services, in a deal that values the company at $840m. The offering price represents a premium of nearly 30 per cent over AmeriPath's closing Nasdaq price of $16.45 in early December.
Apax backs $700m buyout of Calvin Klein
International private equity firm Apax Partners has partnered with Phillips-Van Heusen to acquire Calvin Klein in a transaction that valued the apparel company at approximately $700m. The transaction includes $400m in cash, approximately $30m in Phillips-Van Heusen stock as well as warrants and an ongoing financial incentive for Calvin Klein based on future sales of its brand. Apax's financing came in the form of a $250m equity investment in Phillips-Van Heusen convertible preferred stock, as well as a $125m, twoyear secured note. Under the terms of the agreement, Calvin Klein's existing design and marketing organisation will continue as a separate and distinct operating unit. Calvin Klein will retain a significant financial interest in the combined entity's success and be involved in key strategic issues, including growth opportunities, overall design direction, brand positioning and marketing strategy.
Distressed firms acquire Conseco
Fortress Investment Group, JC Flowers & Co, and Cerberus Capital Management have announced plans to acquire Conseco Finance Corp from bankrupt insurance and lending giant Conseco, which received $500m from Thomas H. Lee in 1999. The price of the acquisition hasn't been disclosed. Conseco's bankruptcy came as no surprise; the company had been talking with creditors for months about restructuring $6.5bn in debt.
Summit exits carpetcleaning franchise
Boston-based Summit Partners has sold its carpet-cleaning franchise, Harris Research, to Nautic Partners, a private equity firm based in Providence, Rhode Island, for $97m. Summit purchased the company, which operates more than 3,800 franchises under the Chem-Dry brand, in 1996 for an undisclosed amount. Nautic Partners is the independent successor to Fleet Equity Partners, a private equity affiliate of FleetBoston Financial since 1986.
AIG Highstar, Southern Union pay $1.8bn for pipeline units
AIG Highstar, a private equity fund sponsored by American International Group that focuses on infrastructure-related investments, has teamed with Southern Union to acquire the CMS Panhandle units from CMS Energy Corp for a total of $1.8bn. The CMS Panhandle units operate 11,000 miles of natural gas pipeline extending from Canada to the Gulf of Mexico. The company has annual revenues of approximately $500m. It was sold to reduce debt. Southern Union is an energy distribution company serving 1.5m customers in the Northeast, Texas, Missouri, and Mexico.
Spectrum, Providence take McLeodUSA stake
Telecommunications investment specialists Spectrum Equity Investors and Providence Equity have acquired Illinois Consolidated Telephone in a $271.2m buyout from Forstmann Little portfolio company McLeodUSA. ICTC, renamed, Consolidated Communications, operates more than 90,000 customer lines in an area just under 2,700 square miles in Central Illinois.
CD&R leads $460m Kinko recapitalisation
New York-based private equity giant Clayton, Dubilier & Rice has led a $460m recapitalisation of copy store chain Kinko's. CD&R invested $175m from its Fund VI, JP Morgan Partners invested $25m and privately owned Kinko's purchased $260m of its own shares. This is Clayton Dubilier's second investment in Kinko's. In 1996, the firm invested $219m from its Fund V for a 29.6 per cent stake in the company.
Clayton Dubilier also saw portfolio company Remington Arms recapitalised when New York-based private equity firm Bruckmann, Rosser, Sherrill Fund committed $30m in equity to the company. Bruckmann Rosser will take over a majority of the company, with Clayton Dubilier's interest falling to no more than 49 per cent. Remington also refinanced approximately $100m of debt and the issuance of an expected $175m in unsecured, interest bearing senior notes.
American Securities acquires Westward Communications
New York private equity firm American Securities Capital Partners has acquired a controlling interest in community newspaper publisher Westward Communications from Stonehenge Partners in a transaction valued at $100m. Westward Communications publishes two Houston-area daily newspapers and 59 weekly newspapers in Texas and Colorado.
Greenbriar, Berkshire, Goldman Acquire $125M of Building Products Co.
New York-based Greenbriar Equity Group and Berkshire Partners in Boston have acquired just over a third of building products manufacturer Hexcel Corp in a $77.9m cash-for-stock refinancing. Goldman Sachs, the investment bank, maintained its position in the company by committing an additional $47.1m from its private equity arm GS Capital Partners. Hexcel designs, manufactures and markets lightweight, high reinforcement products, composite materials and engineered products for use in commercial aerospace, space and defense, electronics, general industrial and recreation applications. The recapitalisation helps Hexcel improve its operating capability and should help the company arrange a new senior credit facility to help it through the economic downturn.
Funds & Buyside
Five VCs announce fund cutbacks
Five venture capital firms – Meritech Capital Partners, OVP Venture Partners, Atlas Venture, Mobius Venture Capital and Mohr, Davidow Ventures – announced they would downsize their funds and reduce management fees. For Mohr Davidow, the cutback was its second. The Menlo Park-based firm has now reduced its most recent fund to $450m from an original $843m. Meritech and OVP waived management fees on their funds to stave off potential clawbacks. Boston-based Atlas announced it would close offices in Seattle and Menlo Park, as well as downsize European offices. Mobius, formerly Softbank Venture Capital, reduced its $1.5bn sixth fund by $250m.
Pension funds post fund performance data
Three of the biggest backers of private equity, California's state employee and teachers' pensions and the investment arm of the Canada Pension Plan, have begun posting fund-level IRR information on their respective web sites. For CalPERS and CalSTRS, the decision to make public its private equity fund performances came as a result of a lawsuit brought by a California newspaper, the San Jose Mercury News. CPP Investment, on the other hand, which has a relatively new private equity programme, requires its general partners to agree to the web site listing. None of the pensions lists portfoliocompany data, easing the fears of many in the private equity industry that the disclosures would go too far.
“Ending this lawsuit frees us to work proactively on developing an industry standard for private equity reporting that allows us to do our fiduciary duty and provide maximum transparency,” William Crist, president of the CalPERS Board of Administration, said in a statement. “We intend to work with other institutional investors, the private equity industry and the public to develop the best reporting standards. The goal of these standards is to meet the needs of public disclosure without creating a chilling effect on our ability to access and evaluate private equity investments.”
Washington, Oregon pass on KKR investment proposal
Kohlberg Kravis Roberts' two biggest investment partners, the state pensions of Washington and Oregon, declined to pay for an equity stake in the management company of the private equity giant, despite having already committed a total of $2.5bn to the firm's new fund. KKR reportedly proposed to sell the pensions 15 per cent of the firm in exchange for $1bn, valuing KKR at $7bn. KKR had hoped to secure a steady source of capital as well as lay the groundwork for an eventual leadership transition at the firm.
“We looked at the structure of the funds and liquidity requirements and determined that the proposals Kohlberg Kravis Roberts made wouldn't fit within the current strategy,” Joseph Dear, executive director of the Washington state pension fund said in an interview with Bloomberg. “Liquidity is something that has to be planned for.”
Leonard Green closes Fund IV, buys map maker
Leonard Green & Partners, the Los Angeles buyout house, rounded up $1.85bn, less than three months after the death of founder Leonard Green. In 1998, the firm's third fund raised $1.24bn. Leonard Green & Partners focuses on middlemarket companies with values of between $200m and $1bn. The firm's latest investment is the acquisition of bankrupt map company Rand McNally for an undisclosed sum.
MPM closes $900M health Fund III
MPM Capital held a final close on $900m for its global venture capital fund MPM BioVentures III, the largest fund raised this year dedicated solely to the healthcare sector. The firm also promoted principal Robert Liptak to become its ninth general partner, added a new venture partner, and promoted three associates to principals in its global investment team.
The new fund will invest in biotechnology, drug development and medical technology companies across Europe, the US, and Asia. MPM will look to invest from $5m to $60m per company, with a preferred investment size of $15m to $25m. It has already made three investments from BioVentures III; in ARYx Therapeutics, a biotechnology company based in Santa Clara; Tercica Medica, a South San Francisco, California-based biotechnology company focused on developing and commercializing therapeutics for hormone-based diseases; and CHF Solutions, a Minnesota-based medical device company with a novel approach to treating and managing the fluid overload experienced by congestive heart failure patients.
Sun Capital closes third fund on $500m
Florida-based turnaround specialist Sun Capital Partners closed its third fund, Sun Capital Partners III, on $500m. The original target of the fund was $400m. The new fund will continue Sun Capital's strategy of investing in companies with strong market positions or franchise value, but with poor performance, significant operational challenges or in industries that are currently out of favour. Sun Capital Partners was founded in 1995 by Rodger Krouse and Marc Leder, former Lehman Brothers merchant banking professionals.
Bessemer managing partner Soni resigns
Rob Soni has resigned as managing general partner at venture capital firm Bessemer Venture Partners, the Massachusetts venture capital manager. Soni, who joined Bessemer Venture Partners in 1994, said his departure was a “cordial parting” over differences in strategy. During his time at Bessemer, Soni invested primarily in semiconductor and communications equipment startups, including Castle Networks, acquired by Siemens for about $300m; Sirocco Systems, acquired by Sycamore Networks for $2.9bn; Aptis Communications, acquired by Nortel Networks for $286m; Ocular Networks, acquired by Tellabs for $355m; and Pirus Networks, bought by Sun Microsystems for $160m.
Austin Ventures demotes three partners
Austin Ventures, the Texas-based venture capital firm, has demoted three of its partners. Stephen Straus, who joined Austin Ventures in 1996 and was named a general partner focused on semiconductors in January 2000, and partner Rob Adams, who was lured away from TL Ventures in 1999 to serve as managing director of high tech incubator AV Labs, will become venture partners. Another general partner, Ross Cockrell, has yet to decide whether he will remain with the firm, where he has worked since 1995.
Pequot promotes two to general partner
Pequot Ventures, the direct investment arm of Pequot Capital Management, has promoted Martin Hale and Aryeh Davis to general partner. Hale, previously an associate at Geocapital Partners, has been with Pequot Ventures since 1997 as a member of the firm's technology infrastructure investment team, where he focuses on investments in wireless telecommunications hardware, software and services for the Pequot venture and private equity funds. Davis has been with Pequot Ventures since 2000 as general counsel.
Chester leaves New York pension post
Paula Chester has quit as director of private equity for the New York State Common Retirement Fund. Chester, who had served as director since 1999, has been replaced by Dave Loglisci, a former vice president at investment bank Salomon Smith Barney. The fund, valued at roughly $100bn, is one of the biggest backers of private equity in the US. Chester's departure coincides with newlyelected New York state treasurer Alan Hevesi taking office.
Walsh pleads guilty to securities fraud
Frank Walsh, a former chairman of influential 1980s buyout firm Wesray Capital, pleaded guilty to securities fraud committed during his tenure as a board member of Tyco International. Specifically, Walsh admitted failing to inform his board about $20m in fees he received for arranging Tyco's acquisition of CIT Group in 2001. Walsh was involved as a principal in Wesray Capital from the time of its formation in 1981 until 1996.
Hicks Muse promotes two to partner
Dallas, Texas-based private equity manager Hicks, Muse, Tate & Furst promoted Joe Colonnetta and Andrew Rosen to partner. The two previously served the firm as principals. Colonnetta joined Hicks Muse in 1999. Previously, he was a partner at C Dean Metropoulos and Co. Rosen joined the firm in 1993. Prior to Hicks Muse, he was an associate with The Carlyle Group.
CalPERS' Flaherman embarks for New Mountain
Michael Flaherman, the chairman of the California Public Employees' Retirement System (CalPERS) Investment Committee, has joined New York-based private equity firm New Mountain Capital Group, in which the pension plan invested $100m to acquire an undisclosed stake. At New Mountain, Flaherman is a full-time senior adviser and a member of the advisory board, helping the firm communicate with its 25 limited partners. He does not have an investment role.
Flaherman isn't the first CalPERS investment executive to switch to one of its contractors. In June 2001 CalPERS private equity chief Barry Gonder joined Grove Street, the Massachusetts-based pension consulting firm, as a partner. Along with Flaherman, five senior CalPERS executives departed in January amid falling returns. Chief executive officer James Burton quit in August 2001 to run the World Gold Council, a metals industry trade group. In November 2001, chief investment officer Daniel Szente resigned rather than battle litigation limiting portfolio managers' salaries.
Bonavitacola joins Schroder Ventures
Schroder Ventures has appointed former Hamilton Lane managing director Marc Bonavitacola to its Boston-based US office. Bonavitacola was tapped to work alongside Solomon Owayda, managing director of Schroder Ventures US, in advising fund-of-funds and third parties on private equity fund selection. At Hamilton Lane, Bonavitacola was an investment committee member and a portfolio manager responsible for the analysis, construction and management of private equity portfolios for clients around the world. He also monitored fund performance and designed customised products and portfolios for clients. Prior to Hamilton Lane, Bonavitacola was the chief investment officer for the $5bn City of Philadelphia Public Employees Retirement System, where he built a private equity programme, which presently stands at approximately $400m in commitments to private equity partnerships and direct investments.
Friedberg, Milstein launch merchant bank
Barry Friedberg, executive vice president and chairman of global markets and investment banking at Merrill Lynch, has teamed up with New York-based real estate mogul Howard Milstein to form a new private merchant bank named Friedberg Milstein. The firm will make investments in leveraged buyouts, recapitalisations, restructurings, and mezzanine financing, as well as advise clients. The firm will seek thirdparty capital once a solid reputation has been established. Milstein and Friedberg worked together briefly in the 1970s at Warburg Paribas Becker, which was renamed AG Becker. Milstein left that firm to begin a career in his family's real estate business.
Howard Milstein and his brother Edward operate Milstein Brothers Capital Partners, an early stage venture capital firm that will focus its activities on investments pertaining to the new group. The brothers also own an advisory firm that will be folded into the new group. The Milstein family controls Emigrant Savings Bank and owns several residential, commercial, and hotel buildings in New York.
Part of Milstein's interest in starting the merchant bank is to diversify the family's holdings beyond real estate and bank holdings.