Not too long ago, some limited partners were vocal in their view that the private equity model was essentially broken – that GPs had become more interested in making easy money through lucrative fee streams than earning it the hard way via carried interest.
So for LPs, the realignment of interests between fund managers and investors in the post-Lehman era has been an important development. Today, most LPs would agree the situation has changed for the better: many have been able to press the reset button with managers and negotiate better terms and conditions, including lower management fees.
However, some LPs currently have a new bee in their bonnets: the fees and expenses GPs are charging to their funds.
“LPs are baulking at the funds paying for private planes and first-class travel,” says one US-based fund formation lawyer. An example he shares involves executives with private jets, which they use for both business and personal travel. “How should costs [related to the ownership of] the plane be allocated?” the lawyer asks noting that these are the sorts of questions he’s getting from LPs.
According to one investor source, expensing “questionable” costs has long been common practice for some private equity firms. “Do they take advantage of it? Of course,” he says. “I think you would be shocked.”
Another LP from a prominent US-based university endowment says his organisation has begun paying much more attention recently to the fees charged by their fund managers.
“We look more carefully at what fees are being charged to the fund versus [what’s being] paid by the GP, as some GPs have clearly tried to move more costs to the fund,” he said.
A typical partnership agreement states that the fund will bear all costs of its operations, such as dead deal fees, outside consultant fees, taxes owed by the fund, and third-party legal and accounting services carried out on the fund’s behalf.
But sources say that a growing number of LPs are questioning which items can be fairly considered fund expenses, particularly with reference to peripheral expenses like early-stage due diligence costs.
Jason Scharfman of Corgentum Consulting, a firm that helps guide LPs through the operational due diligence process, says GPs can make the argument that the LPA gives them discretion on what expenses are charged to the fund.
“But you’ll start to see a shift, where LPs want transparency on this,” he said. “They want to know exactly who’s paying for what, so that more questionable expenses can be discussed.”
LPs are increasingly concerned about what types of expenses GPs are charging to a fund without full disclosure. “They can easily bury these outsourcing costs in the financial statement,” says a fund of funds executive. “It isn’t an itemised expense report.”
The fund of funds manager says he’s suspicious of any firm with billions of assets under management that (for example) has never hired a general counsel to handle various legal services. “A general counsel could handle forms like Form ADV, if they are SEC-registered. But if you don’t have that in-house lawyer, are we paying for that [to be outsourced]?”
New research from the ACA Compliance Group shows that half of private equity firms do not have formal policies in place to ensure that only reasonable expenses are charged to limited partners.
“Written expense allocation policies and procedures establish controls to ensure that firms are allocating expenses consistently with their fund document disclosures, and that the allocation among multiple funds between the management company and funds is reasonable,” says Jack Rader, an ACA compliance consultant. Having a written expense allocation policy is increasingly becoming an “expectation of the SEC and a good practice,” Rader says.
While most GPs do not have formal expense allocation controls in place, 66 percent of private equity firms include expense allocation guidelines in their limited partnership agreements and other fund governing documents, ACA research found. But they make their own rules: most GPs said they do not subject these guidelines to any “reasonableness” review by outside consultants or employees using their own good judgment. GPs will probably argue that this is not a widespread problem. But it’s worth noting that according to the ACA research, 30 percent of private equity firms charge all costs of private jet travel to the fund, while 35 percent charge a first-class ticket equivalent when jetting around the world.
Clearly we’re talking here about ingrained practices that in many cases have been going on for a number of years. But GPs have to recognise that times have changed; we’re no longer living in a world where managers can expect LPs to keep signing cheques regardless. Trying to take advantage of loose expense rules is just a recipe for alienating your LPs and generating negative publicity for your firm.
It’s also a dangerous game at a time when the industry is under increased scrutiny from the US Securities and Exchange Commission – which has consistently warned that expenses charged to investment funds should be clearly disclosed to investors. The threat of the dreaded SEC audit is already causing a few GPs to lose some sleep. And if they’ve got issues like this to hide, so it should be.