According to the old adage: “If it looks like a duck, walks like a duck and quacks like a duck, it’s probably a duck.” In the accounting world, if it looks like a duck, walks like a duck, and quacks like a duck, it’s probably just an independent duck-like entity.
There’s been more than a hint of this in the recent row concerning Kohlberg Kravis Roberts and its operational consulting unit KKR Capstone. The Wall Street Journal reported that although KKR had agreed with investors in its 2006 fund to offset 80 percent of any fees generated by any affiliate against the management fee, it hasn’t been including any of the fees earned when it charged Capstone out to its portfolio companies – on the grounds that Capstone is not an affiliate.
Since the unit shares services (including office space) with and gets most of its work (including 70 percent of the firm’s portfolio companies) from KKR, and since its employees share in KKR’s carried interest pool, the optics of this are difficult, to say the least. To compound matters, KKR has actually referred to Capstone as a subsidiary or an affiliate in various public statements.
However, the firm is basing its position on a 2011 opinion from outside counsel at Linklaters, which states that in the strictest legal sense, Capstone is actually not an affiliate. So any suggestion otherwise was a mistake.
KKR says that because of this distinction, LPs have always been clear that they won’t see an offset from Capstone fees – although it also acknowledges that it has tightened up the language of its post-2011 vintage LPAs, to make it more explicit.
In an emailed statement to Private Equity International, KKR said: “Since Capstone’s formation, we have had an ongoing dialogue with our fund investors about Capstone. We believe they understand the relationship and that our reporting has been transparent. We disclose who pays and receives fees for Capstone’s consulting services in fund documentation and regulatory filings, and we also provide detailed company-by-company information on Capstone fees on a quarterly basis to the advisory committees of all our active private equity funds. There is no question Capstone has a close relationship with KKR. Capstone is often an important driver of value creation at KKR portfolio companies. Ultimately their work helps improve the value of our investments.”
However, this very topic is clearly in the SEC’s crosshairs. At PEI’s Private Fund Compliance Forum, inspections director Andrew Bowden said specifically: “First, since [operating partners] are presented as full members of the adviser’s team, investors often do not realise that they are paying for them a la carte, in addition to the management fee and carried interest. […] Second … operating partners are not usually treated as employees or affiliates of the manager, and the fees they receive therefore rarely offset management fees, even though in many cases [they] walk, talk, act, and look just like employees or affiliates.”
Some LPs are also taking a closer look – like the Oregon Investment Council, which describes itself as “a well-recognised leader in driving down investment fees in order to maximize net returns for beneficiaries”. Chairman Richard Solomon told PEI the system had “directed our consultants and treasury staff to continue to verify that the private equity firms with whom we invest have assessed only those fees allowed by the terms and conditions of their contracts.” (Oregon pension funds have invested with KKR since the 1980s).
Other managers are now facing disclosure requests from investors about their operating partner arrangements. But for the time being – at least until the SEC expresses a more forceful view on the subject – LPs may have to rely on their negotiating skills.