During a recent webinar I moderated, which was organised by sister news service PrivateEquityOnline, the 60-odd participants were asked which of the raft of LP-friendly terms now being proposed with vigour would be hardest for GPs to embrace.
Given the attention surrounding the “European-style” waterfall distribution formula, I had expected that this LPpreferred partnership term would win the poll. Instead, the top pick was deal fees, or rather, GPs being cut off from them. Subsequent conversations I had with major LPs made it very clear that while investors are keen to avoid claw-back situations in the future, they are increasingly adamant that GPs not pay themselves out of the precious cash flow of their own portfolio companies.
Deal fees run counter to the very idea of partnership investing, says the head of the private equity investment staff at a major US pension. They represent a “gross misalignment of interest”, says the head of private equity at an endowment.
At the very least, LPs want the full amount of any deal fees used to offset management fees. The recently released “Private Equity Principles” from the Institutional Limited Partners Association sets forth its suggested approach to deal fees as follows: “All transaction, monitoring, directory, advisory and exit fees charged by the general partner should accrue 100 percent to the benefit of the fund.”
Deal fees appear to be in the final stretch of a long journey from GP-take-all to LP-take-all. In the early days of the buyout industry, some GPs built outrageous fortunes charging investment-banker-style fees to their portfolio companies, not all of which ultimately delivered attractive IRRs for the investors. An increasingly sophisticated LP base eventually argued successfully that some or all of these fees should be shared in the form of management-fee offsets. Now the market standard for these fees hovers between 80 percent and 100 percent going to the LPs.
But that's not good enough for many of the very influential LPs I've spoken with recently. Some find the practice altogether distasteful and are looking for GPs who mostly eschew this source of revenue.
They find it irksome that certain GPs cling to the notion that it is their right to build wealth from fees charged to the portfolio. The arguments against GPs keeping these fees for themselves are many. How, for example, can a GP say with a straight face that he is incented to maximise the value of a portfolio company when siphoning digits out of its EBITDA, the number upon which its sale price will be based? How can he deny that the sting of an underperforming portfolio company is salved by deal fees, but only on the GP side of the partnership? Isn't it obvious that the manager of a bunch of dud investments becomes perversely incented to begin extracting maximum deal fees, since there will be no carry at the end of the fund?
There are arguments for deal fees. Managing a firm is expensive, and the fees don't only go into the pockets of the individual partners but toward the strengthening of the management company. The fees are usually shared with the LPs, which reduces the management fee drag earlier in the fund's life. The fees may nominally affect the earnings of the portfolio company, but any resulting small drop in the exit value is offset by the enhanced cash flow of the partnership.
But in today's market, these arguments don't carry much weight among LPs, who have a laser-like focus on alignment of interests. The endowment head I spoke with said he already separates the buyout landscape into two camps – those GPs who rely on deal fees and those who don't. He says he and many of his peers are very aware of groups that have passed on investment opportunities where their clubdeal partners have refused to charge deal fees to the acquired company. In other words, when asked to join a consortium for an otherwise attractive investment opportunity, certain GPs have refused because “they wanted to force everyone to take a transaction fee,” says the endowment pro. “They've gone as far as to say that their business models are dependent on transaction fees and so they're not going to do it.”
Be warned – when an LP asks you about your term for keeping 20 percent of deal fees in your next fund, there may be a lot more righteous indignation behind this question than is immediately obvious.