In the previous two posts we’ve been summarizing some of the insights provided by Michael Flaherman, Visiting Scholar at UC Berkeley and long time veteran of the industry who presented the IMDDA webinar “Making Sense of Private Equity Partnership Agreements”. We’ve helped you to understand private equity fund due diligence and examine some of the key reasons why the management fee offset deal you think you’re getting may not be as good as you think it is.
In this final post from the webinar on improving private equity fund due diligence outcomes, we look at some of the tactics you can use to make your private equity operational due diligence more effective.
Question relationships with special advisors
The fees accrued in relation to special advisors and consultants are only subject to management fee offset if those individuals are defined as “affiliated” with the private equity firm you are partnered with. Your due diligence should cover questioning the nature of the relationship between the special advisors and the firm. Where you find they are affiliated in all but name you can challenge their status as truly independent actors.
Also worth looking for are any stated exceptions around fees to affiliated broker-dealers, which are often included as a clause saying they're not subject to offsets either.
Examine third party relationships and fees
Beyond portfolio company fees, your private equity fund due diligence will need to take a look at other key relationships the private equity firm maintains with businesses who supply products and services to the portfolio companies themselves. Often marketing presentations will make mention of how the private equity firm brings special capabilities to its portfolio companies, for example making them more effective at purchasing. Dig beneath the surface. This often means the private equity firm refers all their portfolio companies to a single supplier, who as well as offering favorable terms to the portfolio company also furnishes the private equity company with referral fees or kickbacks based on the amount of business done with the portfolio companies.
Look at legal costs
In the detail of your partnership agreement, you may find wording around the payment of legal fees that outlines the fact that your fund will be charged back legal fees at full rates or even an inflated premium rate when in fact your GP is receiving these fees at a discount. Private equity operational due diligence should check for discrepancies here.
Think about tax receivable agreements
Often, when a portfolio company goes public they’ll sign a tax receivable agreement with their former private equity owner, giving them the right to a large percentage of the tax savings they’ll net from going public, over a period of years. The issue here is that this may be a period of 15 years after going public and you need to look at whether any of those fees will come to your fund. Often, agreements are structured in such a way as to end your rights to any of these payments as soon as you cease to own a stake in the portfolio company, meaning years of lost revenue.
Don’t leave it to legal review
You must include a review of your partnership agreement in your own private equity operational due diligence process. You can’t assume that the issues we’ve outlined in this series of posts will be picked up by legal review, as identifying them requires knowledge of how LPAs are applied in real world situations, such as we’ve explained here.
Ask for copies of all fee agreements
Finally, don’t just look at your own partnership agreement. Take a look at a copy of all the fee agreements a private equity fund manager has with their portfolio companies and relevant third parties as outlined above. Drill down into what’s supposed to be being paid to them, query what’s been paid and what hasn’t and if they say payments haven’t happened ask why they haven’t when they’ve been agreed to.
To get more detail on how to be an effective private equity operational due diligence manager, listen to the rest of the webinar here: