Investors Like CalPERS and New York City in the Dark About Private Equity Fees

This anodyne-seeming section from a video at Privcap on The Future-Proof LPA [Limited Partnership Agreement] contains a real bombshell:

Consider what this means. Steve Miller is a private equity industry expert who works for the general partners, or GPs, meaning the private equity firms. He ‘fesses up that most private equity firms are not disclosing the fees they take from portfolio companies to their investors. Revealingly, Miller depicts a May 2014 speech by the former SEC exam chief Andrew Bowden in which Bowden called out grifting and other sharp practices in private equity as “infamous”. Recall Bowden’s discussion of fees:

Many limited partnership agreements are broad in their characterization of the types of fees and expenses that can be charged to portfolio companies (as opposed to being borne by the adviser). This has created an enormous grey area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors…

So … when we think about the private equity business model as a whole, without regard to any specific registrant, we see unique and inherent temptations and risks that arise from the ability to control portfolio companies, which are not generally mitigated, and may be exacerbated, by broadly worded disclosures and poor transparency.

Thus, Miller admitting that nearly a year after the Bowden speech, the general partners have yet to come clean. And do not forget that the vagueness of the limited partnership agreements and the lack of adequate monitoring by the investors facilitated the abuses the Bowden cited:

When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.

But at least as bad is that the investors themselves, who ought to know what they don’t know, act as if they have a good grasp on what they are paying to invest in private equity. But remember, there are multiple ways that they get nicked. They pay an annual management fee, the prototypical 2% of the “2 and 20” and a 20% profit share, or carried interest, paid on returns that exceed a hurdle rate, typically set at 8%. But the investors also pay fees via charges made directly to portfolio companies, such as the “fee for nothing” or monitoring fee and transaction fees. Remember that fees that come out of the portfolio companies, which were purchased by the investors’ funds, are every bit as much money out of their pocket as the fees that they are pay explicitly.

But bizarrely, investors not only don’t worry their heads about all the obscured fees they are paying at the portfolio company level, they also do not even calculate their visible costs correctly.

Investors are blind to fees and expenses charged to portfolio companies. Consider a report earlier this week in the New York Times, which stated that New York City had missed significant fees in calculating its investment results, dragging its returns down to levels it considered to be unacceptable. The Grey Lady issued a correction after private equity reporter Dan Primack of Fortune shredded the article, pointing out that the Times had attributed the overlooked fees to private investments when in fact they came from public investments like stocks and bonds.

However, notice that New York City’s effort to be more comprehensive in capturing its total fees paid to Wall Street completely missed the fact that substantial charges are paid directly by the portfolio companies to the private equity firms themselves. That means their supposedly new, improved calculation of fees almost certainly still underestimates the cost. They didn’t take into account fees charged to portfolio companies, since they would have had no direct way of knowing the extent of those fees.

Even supposedly sophisticated investors like CalPERS kid themselves about the fees they are charged at the fund level. Even though the fund-level charges are visible, investors often willfully understate them.

The most obvious and predictable fee is the management fee, which is a set percentage that normally declines after the initial investment period. Remember that the amount that investors pay in cash is reduced by so-called management fee offsets. That means that, say, instead paying $2 million on a $100 million commitment, a fund will have that amount reduced by a percentage, typically 80%, of certain specified fees charged to the portfolio company. So let’s say across all portfolio companies in a particular fund, an investor’s share of the all those fees is $1 million. Its management fee bill would therefore be $2 million minus 80% of $1 million, or $1.2 million.

But that does not meant its management fee was $1.2 million. Its fees were the $2 million plus the portion of the $1 million not offset against the management fee, or $200,000, plus any sneaky fees not subject to be offset against the management fee. Oh, and the investor also pays for other indirect charges, like the carry fee deducted from the proceeds of sales of companies, as well as expenses paid by portfolio companies, like the private jets used by the private equity minders.

Industry leader CalPERS, and we suspect most of the rest of the industry, makes the inexcusable misrepresentation of counting only the fees they pay directly in their fee calculations. As we wrote in a January post, commenting on a presentation at a CalPERS open board meeting:

Let’s see how a recent board meeting revealed how embarrassingly superficial a view CalPERS’ staff has of its actual costs….

This exchange between the new head of private equity, Réal Desrochers, and board member JJ Jelincic, confirms the worst fears…The discussion starts at 1:26:20:

So let’s see what we learned:

1. Desrochers confirms that the slide only covered management fees and therefore ignores the whole cost. He offers to discuss carry fees in closed session, meaning privately. Why is this not a matter of public disclosure like the management fees paid out?

2. Derochers frighteningly does not seem to appreciate that even if the fee offsets worked the way the limited partners naively assumed they do, that the effect would be that they would still be bearing the cost of the full management fee. Notice his statement at 1:30:15 that “I don’t know how many years where the LP did didn’t have to pay any fee because they were charging to the company. And they were reimbursing the management fee.” This is classic drunk under the streetlight thinking of focusing on what is visible as opposed to what is relevant. It’s just that some of it is paid in hard dollars and some in charges to their investee companies. As Jelincic points out, CalPERS still bears all costs of the management fee. At that point, Desrochers either relents or corrects the impression he gave earlier.

And as seems to be par for the course for the industry, Desrochers evidences no concern that limited partners get ONLY a share of fees specifically enumerated in the limited partnership agreement, and that the fee rebates top out at the amount of the management fee actually paid.

Why does this matter? It undermines the CalPERS push to reduce fees in isolation. It’s reminiscent of the person who thinks they are on a really stringent diet because they’ve cut out a lot of fat while ignoring that they are winding up eating more food to feel satiated, and hence not anywhere near as far ahead as they think they are.

The more that CalPERS drives the management fee down, the greater the odds that that effort will be vitiated by the fact that the portfolio company level fees will exceed that, meaning all those efforts to get a better break were largely for naught.

Mind you, CalPERS is, for the most part, as good as it gets among private equity investors.

So why do investors actively enable the understatement of the true costs of investing in private equity? Are they simply classic cases of Stockholm Syndrome, of identifying so strongly with their captors that they are afraid to rock the boat by asking tough questions? That seems at best a partial explanation, since CalPERS is perfectly capable of making a more honest presentation even with the limited data it has. The “don’t undermine the relationship” thinking extends even further, to apparently not wanting to know what private equity investing really costs, since if the total charges were exposed, it might well create such a ruckus at to make continued investing indefensible, absent a regime change that the private equity overlords would fight tooth and nail.

And the greatest irony is that the limited partners have convinced themselves that they have “relationships” with private equity firms, as opposed to being the mark at the gambling table. Private equity general partners exemplify the Sharon Stone saying: “Women can fake orgasms. Men can fake entire relationships.”