US private equity firms have charged their portfolio companies $20 billion in “hidden fees” over the past 20 years, according to a study from Oxford University’s Saïd Business School.
The paper, “Private Equity Portfolio Company Fees” questioned what the fees, which it described as “economically relevant”, were for on the basis that the GPs already received a management fee.
It scrutinised 1,044 investments in 592 portfolio companies with a total enterprise value of $1.1 trillion, and found that fee payments totalled the equivalent of 6.4 percent of GPs’ equity investments from 1995 to 2014.
The California Public Employees Retirement System (CalPERS) would have paid $2.6 billion in portfolio company fees on $41.4 billion invested across funds from 1991-2008, without accounting for rebates, the report said.
The pension system has been a lightning rod for criticism regarding its ability to track fees. It launched a new reporting system in early October and has begun to publish carried interest data, as reported by Private Equity International.
“Portfolio company fees do not seem negligible for LPs,” the report said.
Margot Wirth, head of private equity at California State Teachers’ Retirement System, told PEI in November that “LPs have waged a long-term battle for at least 15 or 20 years and driven these fees down to such a point that for the next generation of buyout funds, the majority, have 100 percent offsets.”
Wirth added: “That’s important both because they’re so significant and also because they’re hard to track and less objectively specified.”
The study’s lead academic Dr Ludovic Phalippou told PEI that the fees were described as “hidden” as the amount charged was unknown by LPs. He flagged the potential conflict of interest generated by charging fees to a company where a manager sits on the board.
The report raised the question as to whether the fees charged were legal but did not offer any conclusions. “In the case it is legal, the SEC [US Securities and Exchange Commission] should not be fining firms. If it is illegal the fines should be higher,” Phalippou said.
The report noted that the firms pursued by the SEC for charging illegal fees might not necessarily be the ones that charged the most.
In a recent example, the SEC settled in October with Blackstone for $39 million for charging accelerated monitoring fees, a type of charge that the report describes as “the most controversial”.
Over the 20-year period, transaction fees totalled $10 billion, the equivalent of 0.9 percent of aggregate total enterprise value, with monitoring fees reaching the same amount. From 2008 to 2014, the four largest GPs — Apollo Capital Management, Blackstone, KKR and The Carlyle Group — earned $2.5 billion in net monitoring and transaction fees, using the study's assumptions.
Other fees, including $2.4 billion of refinancing fees, director fees, break-up fees, expense claims, and “kick-backs” from portfolio company suppliers were not included in the study.
The study did not investigate expenses due to lack of data, which Phalippou said “may be the elephant in the room”.
“Expenses charged by GPs to portfolio companies may present the largest potential for conflicts of interest,” the study said. “We do not have data to analyse expenses or potential kick-back arrangements but it would be a natural follow up study.”
Industry, earnings volatility, leverage and GP ownership had little impact on fees, which were equally distributed over time, and neither did business or LBO cycles. “Fees are not higher at times when it is more difficult to execute or monitor LBO investments,” the report said.
The level of transaction and monitoring fees charged to companies has not change pre- or post-crisis, Phalippou said. “The anecdotal evidence is that the rebate [to LPs] has gone up, but that is not obvious. The fees have stayed constant.”
At best, 85 percent of fees were rebated by GPs from 2011-2014, the report said.
One key finding of the report was that firms that charged lower fees were more successful in raising larger funds. Phalippou noted that there was no concrete evidence for why this was but speculated that either LPs were put off by high fees charged and decided not to allocate capital, or linked low fees to high corporate governance and rewarded firms accordingly.
Among the low fee-charging firms listed in the report are Advent International Capital, which is targeting $12 billion for its latest fund, and Hellman and Friedman, which raised $11 billion in 2011.
Half of funds charging high fees have not raised new funds since the crisis, the report noted. “GPs that charge the highest fees tend to be outliers, small, young, and raise significantly less capital going forward,” it said.
Phalippou, who has been researching private equity fees for the past 10 years noted that the data was not available prior to 2012. “I thought fees was an important question. Only recently did the market think it was important,” he said.