In our last post, “Understanding private equity fund due diligence” we looked at the key area of focus for private equity fund due diligence, management fee offsets. This drew on the expertise of Michael Flaherman, Visiting Scholar at UC Berkeley and long time veteran of the industry who presented our webinar “Making Sense of Private Equity Partnership Agreements”.
In this article, we’re going to again leverage Michael’s expertise and look at some of the specific reasons he’s been able to identify that signal that the deal you think you’re getting on management fee offsets may not actually be so.
1. Expense reimbursements
Covered at the end of the previous post, expense reimbursements are not subject to being part of the management fee offset. “Great”, I hear you say, “not a worry for operational due diligence then.” Wrong, sadly. Not only are expense reimbursements a very effective way for private equity firms to claw back millions of dollars annually from their portfolio companies that they don’t have to then split with investors, they’re also an area that isn’t subject to SEC disclosure, meaning that the area is ripe for abuses and excesses that can cause damage to your firm’s reputation.
Where a co-investor is involved (or other similar vehicles), your fund will in most cases only benefit from a management fee offset against the allocable portion of any fee paid to the general partner. And this split is usually defined by the investment partner. So, if they decide that 65% of the fee is allocable to your fund and 45% to the co-investor, that’s all you’ll see of that fee. What happens to the other 45%? Well, as the co-investor isn’t paying any management fees to offset against, the private equity firm keeps their share. Giving them adequate incentive to make sure the allocable percentage does not work in the fund’s favor.
3. Management fee waivers
Where fees are waived but there is either no refund mechanism in place or the amounts involved are deemed too small to be accrued for the management fee offset, the GP will keep the balance for themselves. You may think this is no big deal, but it can really add up over the life of a fund and is worth looking into for your private equity operational due diligence.
4. Fees generated late in fund life
The basic principle here is that if fees are generated late in the life of a fund so that your fund is no longer paying management fees, then there is nothing to offset against and so you lose your right to a share of fees generated during that period.
A related issue is what Flaherman refers to as stranded funds, where you have an AIV created to house a single investment and management fees are allocated against that AIV. As soon as the investment within the AIV is sold, the AIV goes out of business that same day and the GP keeps the associated fees, because there is no imperative to aggregate portfolio company fees from individual AIVs.
5. Excess fees
By their very nature, management fee offsets can only be applied until the management fee stands at $0. There are tax implications of doing it any other way, so your fund manager can’t permit you to exceed this or to roll “credit” over into subsequent years. And on the surface, this seems a very reasonable and rational. Until you look at what many fund managers do to exploit this issue i.e. stacking fees into specific years to ensure the maximum possible excess, that then they (tragically) have to keep for themselves.
What can you do?
- Analyze your partnership agreement for clauses relating to the above 5 key areas.
- Ask questions about how each is handled in practice and what the fund manager does to offset the risks you have identified.
- Ask for copies of the fee agreements your GP has with their portfolio companies and assess whether the clauses in them will expose you to any of the issues outlined in this article.
Want more insights into private equity fund due diligence? The full webinar recording is available now, complete with real examples on every point in this post.
Photo from Freepik