The fees that private equity firms charge investors are coming under increasing scrutiny as the US regulator steps up its examinations into the sector and hands down fines.
So far, the SEC has focused on three categories of misconduct, targeting advisors who receive undisclosed fees and expenses; advisers who misallocate expenses or shift them without permission; and advisors who fail to disclose conflicts of interests, including conflicts arising from fee and expense issues.
Just last week, buyout giant Apollo Global Management agreed to a $52.7 million settlement with the SEC for allegedly misleading limited partners in four funds over fees, while distressed debt investment firm WL Ross agreed to pay a $2.3 million civil penalty for allegedly failing to disclose the method used to allocate certain fees it extracted from investors, the SEC said.
Ludovic Phalippou, an associate professor of finance at Oxford University’s Saïd Business School, specialises in private equity, and co-authored a study that found GPs have charged investors almost $20 billion in “hidden” fees over the past twenty years.
These include what’s known as transaction and monitoring fees, the two main fees paid by a private equity-owned company for advisory and other business-related services performed by the buyout partners who sit on the company’s board. The transaction fee is applied when a company is bought, or when the private equity owners make bolt-on acquisitions, while monitoring fees are typically applied every quarter while the portfolio company is under private equity ownership.
In the Q&A below Phalippou tells Private Equity Internationalwhy he thinks the UK’s Financial Conduct Authority should follow the SEC’s lead and examine the fees that UK-based private equity firms are charging their investors, sometimes, says Phalippou, without LPs realising it.
When contacted by PEI, the FCA declined to comment on Phalippou's critique and recommendations.
Q. How are transaction and monitoring fees currently disclosed, and why is there a lack of transparency?
A. GPs don’t detail the amount of the fees they charge portfolio companies in the LPAs [the limited partnership agreement, which spells out the terms of the relationship between the fund manager and the investors.] The fees are in the MSAs [management services agreements, which specify how much the private equity firm will be paid for services performed on behalf of the portfolio company], signed after the LPA. LPs therefore have no say about these fees, and if GPs want to abuse their powers, they can. LPs are giving GPs carte blanche; the private equity industry thinks it’s normal, but it is rather surprising for any outside observer.
Q. Are undisclosed fees an issue for UK-based GPs as well, or is this mainly a concern with US-based funds?
A. I think it’s going on in the UK too, but I have not found reliable data on this yet. British GPs I spoke to about it told me that these fees are being charged in the UK, but they are lower than in the US. Quite amusing: once, a British GP simply said that the key difference between the US and the UK market is “the level of testosterone”: US GPs are much more aggressive about charging fees.
Q. How has the FCA responded so far?
A.I’ve talked to senior people at the FCA, and I’ve said “You should look into [private equity monitoring and transaction fees]; you wouldn’t allow these kinds of charges in publicly traded companies, why would you allow it in privately held companies? There should be coherence in applying regulation.”
What they’ve told me is that investors haven’t asked for their help. But to my knowledge, the FCA doesn’t have to wait for a mandate before launching an examination, they can choose to launch one. So far, the FCA isn’t doing anything. They have a mission [to “make financial markets work well so that consumers get a fair deal”]; they have a fiduciary duty, and it’s being neglected.
Q. Why do you think there’s a need for the FCA to step in, why can’t the industry police itself?
A. I’ve been researching private equity fees for many years, since well before the US regulator started looking into it. What triggered the SEC’s actions was the 2010 Dodd-Frank Act, which strengthened the SEC’s powers to oversee investment firms, and imposed more reporting requirements on fund managers. It takes enforcement, like a fine, to scare the industry into changing.
Q. What policy recommendations would you make to the FCA? If you could design the regulatory structure governing private equity fees, what would it look like?
A.I would recommend that the FCA does what the SEC is currently doing, and that both the SEC and the FCA apply the same rules to private companies that they apply to public companies: someone sitting on a board cannot directly or indirectly receive, via its employer, any cash from the company being supervised unless it can be demonstrated that the fees were related to a service that was necessary, and the amount charged is arms’ length. The same for expenses.
In addition, anything charged, be it an expense, a fee, or whatever, should be disclosed fully and in detail to the LPs.