Private equity has a reputation for being a tricky area for due diligence professionals to navigate. In addition, it is also known for some of the more controversial practices in the industry. For example, the 2014 SEC statement entitled “Spreading Sunshine In Private Equity” highlighted that more than 50% of the private equity firms that had been investigated by the SEC had been found to be doing something illegal or contrary to regulatory standards.
The IMDDA hosted a webinar “Making Sense of Private Equity Partnership Agreements” with Michael Flaherman, Visiting Scholar at UC Berkeley and long time veteran of the industry. Much of his work involves digging into the detail of how private equity firms do business and it is that level of granular knowledge that he was able to share in the webinar to inform your due diligence strategies.
In this article, we look to understand at a top level the biggest area of concern for private equity fund due diligence: management fee offsets.
What are management fee offsets?
When you invest with a private equity firm, you can benefit from management fee offsets. This is where your standard management fees are discounted by means of offsetting them against fees obtained by the private equity fund manager, usually from their portfolio companies but sometimes other third parties too.
This means that what you actually hand over in out of pocket expense on management fees is often far lower than the quoted fee, if it is anything at all.
Surely that’s a good thing?
In theory, yes this is a great idea. But in reality, there are several issues that you should take into account when doing private equity operational due diligence. Firstly, there’s the issue of transparency.
When you start to offset management fees, you enter a far more complex scenario than the simple payment of a fee for a level of service defined in a single agreement with the general partner. You need to understand where your offset comes from, who has paid what to the general partner in order for the offset to be generated and how it is applied.
Secondly, there’s something that Flaherman refers to as “the gap”. That is, the gap between the offset applied to your fees and the fees actually being collected by the private equity firm. In his experience there are many, many ways in which your general partner may operate that enable them to only attribute a percentage of the fees they collect as your offset. This could be costing your fund billions of dollars over time.
Understanding “the gap”
There are a huge number of potential contributing factors that go to making up the gap between what you are nominally told you should expect from your management fee offset and the reality of what you actually receive.
Not only do many of these practices see the private equity firm pocket the extra money for themselves, they are also practices that can walk the line of legal or regulatory acceptability, attracting unwanted scrutiny from regulators or the media and potentially incurring reputation damage for your fund as well as leaving you out of pocket to the tune of millions if not billions of dollars.
An example of the kind of thing that would be excluded from your management fee offset is expense reimbursements, where the portfolio company pays out of pocket expenses for the private equity firm associated with work done on their behalf.
This seems innocent enough, but in reality can mean the private equity firm claiming about a million dollars annually per portfolio company, the detail of which isn’t disclosed to the SEC and has been found to include bankrolling a fleet of private jets for 5-6 senior execs and any number of other newsworthy excesses.
What does this mean for private equity fund due diligence?
There are two key things you’ll need to do to make sure your private equity fund due diligence is more effective:
- Understand the issues: The example given previously of expense reimbursement is just one of many that need to be understood in order for you to perform effective private equity fund due diligence. We’ll cover more of the main ones in the next post.
- Ask the right questions: Once you know where to look, you need to actually question those areas and make an effort to understand the real work applications of your private equity partnership agreements.
These two tactics, applied early on, will allow you to adjust the terms of your agreements to protect your fund or to politely walk away from opportunities where the interests of your fund aren’t aligned with those of your private equity manager.
Want to know more about current thinking in private equity operational due diligence? Get access to the full webinar recording which is available now by clicking the image below.
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