Transparency: papered up

Late last year, news broke that Los Angeles-based private equity manager Freeman Spogli was allowing its limited partners to bring in an independent advisor to monitor how the firm’s latest private equity fund’s expenses will be administered.

The New York Times reported that Freeman Spogli had made the decision following an SEC review of the firm’s operations, which revealed how fee-sharing between the general partner and the investors had been handled in the past. According to the newspaper, the SEC found that claimed fee off-sets hadn’t actually been offset, and asked the firm to reimburse those Freeman funds that had been impacted, and provide evidence when it had done so.

The story fits neatly into the broader development of regulators and investors taking an ever closer interest in private equity firms’ fee-charging. They are asking whether or not GP services rendered at the portfolio company level, such as healthcare advisory or centralised procurement, are being paid for out of the management fee, or whether LPs are being billed separately, and if so how transparent the relevant arrangements are to them.

Freeman Spogli is not alone in having to rework its modus operandi on expenses. Following similar queries from the SEC, both Blackstone and TPG have recently altered their marketing documentation in order to provide greater visibility on ancillary charges. Kohlberg Kravis Roberts has also made headlines recently over the way it has been charging portfolio companies for services rendered by KKR Capstone, its consulting affiliate.

Blackstone declined when PEI asked for comment, but according to Bloomberg, it has said it could earn up to $20 million from investors in its latest LBO vehicle for ancillary fees.

When PEI spoke with Andrew Bowden, director in the SEC’s Office of Compliance Inspections and Examinations last year, he noted then that one of the things the SEC was focused on was the magnitude of the charges occurring in a given case. If it’s a “coin flip” on who pays, he said, then it was unlikely the SEC would have a problem. $20 million, however is more than a coin flip, and it is not surprising that Blackstone’s latest offering has peeked the SEC’s interest.

Indeed, the SEC’s recent release of its examination priorities put fee arrangements squarely in the regulator’s crosshairs. Importantly, as Bowden and his colleagues see it, according to what he told PEI last year, the point is not that private equity firms can no longer charge these fees; the point is they need to disclose them better.
In light of all the scrutiny, it now seems a certainty that the way GPs and LPs negotiate fund expenses is going to change.

“I think we are in for a broad redefinition of the LP agreement,” David Fann, president and chief executive officer of private equity-focused pension advisory TorreyCove Capital Partners, told PEI. “Those agreements are likely going to be more robust going forward. Firms are going to have to reconsider how they handle those expenses.

Fann thinks the process has only just started. “Everyone is going to have to pull out their pencils and decide on what is equitable treatment. You might see some fees get pushed in with others that have offsets or others may just be eliminated. We’re in early innings, but I think you’re poised to see significant changes. This is part of what happens when industries mature; private equity will have to go through that process too.”

So far, the SEC hasn’t laid out what it views as the ideal approach to fees and expenses disclosure. But fund formation lawyers say changes like those at Freeman Spogli and Blackstone are de facto creating a loose framework that could foreshadow what’s to come. They say that when it comes to papering up new limited partnership agreements, investors have started pushing back on expenses they feel were previously unclear. As a result, the fee structures of future generations of private equity funds are shaping up to be presented to LPs in plainer language than before.