If you have not done so already, please read the preceding posts in our CalPERS’ Private Equity, Exposed series:
• Executive Summary
• Senior Private Equity Officers at CalPERS Do Not Understand How They Guarantee That Private Equity General Partners Get Rich
The oversimplifications, mistakes, and refusals to answer basic questions by CalPERS staff members at the last Investment Committee meeting of its board suggest that CalPERS has so little understanding of private equity that it cannot responsibly invest in that strategy at all. These errors related to concepts that are fundamental to understanding the economics of a private equity investments and hence to negotiating them.
In a must-read post, CalPERS Can’t Explain Private Equity, Andrew Silton, former Chief Investment Advisor to the State Treasurer of North Carolina, wrote:
As I watched the staff for the better part of two hours, I could only think that CalPERS shouldn’t have $30 billion in exposure to private equity and probably upwards of $45 billion in future commitments. The senior staff of the world’s largest public fund cannot readily explain the basics of private equity investing and doesn’t demonstrate mastery over its investment portfolio. As I listened to Mssrs. Eliopoulos, and Desrochers I heard lots of platitudes about transparency, due diligence, and alignment of interest, but very few specifics. Although CalPERS has been investing in private equity for decades, I heard comments and questions from the trustees (and these are the trustees on the Investment Committee) that I would have expected from a public pension plan that had never invested in private equity before. Moreover, when one or two trustees asked pointed questions, it seemed as if the senior staff was doing a fine impression of evasive private equity executives instead of acting as a staunch stewards of a public pension.
Recall that earlier this year, Wylie Tollette, the Chief Operating Investment officer at CalPERS, tried excusing the giant public pension fund’s failure to keep tabs on the private equity profit-sharing payments widely called “carry fees” by claiming that no one in the industry could obtain the information. CalPERS had to reverse itself quickly in the face of a firestorm of industry and media criticism.
We’ll continue our discussion of a presentation by Réal Desrochers, who has the day-to-day responsibility for the private equity portfolio.
CalPERS Managing Investment Director of Private Equity Does Not Understand How Management Fees Work
Desrochers presented the last item on the agenda for the Investment Committee meeting, a very simplified presentation to the board of how “carry fees” work. We’ll turn to the presentation proper in later posts. Suffice it to say for now that private equity experts who have read it concur with our view that Desrochers’s presentation has been oversimplified to the point of being misleading. For instance, Eileen Appelbaum, co-author of the highly-regarded book Private Equity at Work, called it a “ludicrous example.”
Board Member JJ Jelincic: The presentation is good as far as it goes. It’s very high level. But one of the things that it did is that it assumed away the things like offsets and fee waivers and clawbacks and fund costs and preferred returns, which are all the areas that are creating the controversy.
These are the areas where the SEC has said limited partners are getting ripped off, where the IRS has said it looks like taxpayers are getting ripped off. So I want to dig a little deeper, if I may….
Jelincic then describes a 2005 vintage fund he’s picked out as being representative and tries working through the fund economics.
Jelincic: But when I looked at the CAFR [CalPERS’ Comprehensive Annual Financial Report] on this particular fund, one of the things that I see is the fees and costs we report. And I would assume that the fees are the management fee and the costs are all those costs that go into the fund, the auditing fees, the advisory firm, all that kind of stuff. Is that a reasonable assumption?
Managing Director Desrochers: There’s — I don’t know. There’s three types of — there’s in a fund, a co-mingled fund, you have the management fees that are paid, you have sharing of the profit, and you have all sorts of…
Jelincic: Sharing of what?
Desrochers: Sharing of the profit, the carried interest.
Jelincic: Oh, OK.
Desrochers: Then you have fees that are charged to portfolio companies that are to be shared with the limited partners. And then these are market, market driven. Some, if you go to the cycle, you say 2005 vintage year, I don’t know what the name of the fund, but a fee of seven….
If you know a smidge about private equity, this interaction is stunning. Jelincic asks a complete softball question: Do the fees that CalPERS reports in its annual report as fees and costs include the management fees plus the costs of running the fund, like the auditing firm?
If you listen to Jelincic’s question and watch his body language, he expects to get agreement. He looks to be going through what he thinks is obvious background, presumably for the benefit of the other members of the board, to set the stage for his real question. But Desrochers goes on tilt and shunts the conversation to fees charged to portfolio companies, which are not fees paid directly by CalPERS, and he flounders there too.
No interpretation of what happened is pretty. Either Desrochers does not know what the normal operating expenses of a private equity fund are, or he is so unwilling to answer any questions about private equity that he’ll put as much noise as he can in his signal so as to grind any inquiry to a dead halt.
And immediately after that (starting at 1:21:20 on the video), the chairman of the Investment Committee, Henry Jones, intercedes on behalf of Desrochers, in what is clearly an effort to shut Jelincic down by arguing that Jelincic should not be asking questions that require specific figures for a response, that Jelincic instead should give the questions to staff and allow them to provide a detailed response. (It’s almost certain that any such response would not take place in an open board meeting and hence in view of the public). Jelincic replies that Desrochers does not need to know the details to answer his questions.
In a remarkable sequence, Jones indicates that he is still opposed to the questioning. Jelincic asks if he is being ruled out of order. Jones first says no. Then as Jelincic continues, Jones reverses himself and rules Jelincic to be out of order. Jelincic appeals the ruling and asks for a roll call vote. Jones loses control of the meeting. Committee member John Chiang suggests that Jelincic restate his question to be more general. Jelincic asks if Jones is reversing his ruling. Jones gives an equivocal answer, but says a general question is acceptable.
If you doubt that Desrochers is either being obfuscatory in the extreme or is in over his head, what happens as Jelincic presses on provides incontrovertible proof otherwise.
Regular readers of our private equity posts will recall that the SEC and the media have exposed a great deal of misconduct as far as so-called management fee offsets are concerned. Recall that the prototypical private equity fee structures is “2 and 20”, for a 2% annual management fee based on the amount of capital committed, and a 20% share of the profits after a certain level of return (the “hurdle” or “preferred return”) has been met, usually 8%. But private equity firms are also allowed to charge the portfolio companies directly with fees that are paid to the general partner or related parties. Rather than tell the general partners to cut it out, the limited partners have instead agreed to the device of the “management fee offset,” in which a portion of these portfolio company fees (now averaging 85% across the industry) are charged against the management fee. The net effect is to shift a part, and in some cases, all, of the management fees from being paid directly by the limited partners to being indirect charges, pulled out of the portfolio companies.*
Jelincic returns to his 2005 vintage fund example. The facts he pulls from it are simple: 1.5% management fee, so that with CalPERS’ commitment amount, the annual management fee should be $180 thousand. But the CAFR shows CalPERS paid only $30 thousand.** He asks Desrochers for what could account for the disparity. If you look at the video, you will see Desrochers responding like a hostile witness in a trial.*** He fails to mention the most obvious reason, the management fee offset. When Jelincic brings that up, Desrochers then tries the tactic of saying at considerable length that the offsets vary by fund as a way of again dodging the issue. Jelincic continues:
Jelincic: Let me repeat the question. If the manager charges fees to the portfolio company and shares that with the LPs, would the LPs’ management fee be reduced?
Desrochers: Yes.
Jelincic: Okay. And the — because the GP got the same amount of fees, but they got part of it from the portfolio company, and part of it from the LPs, correct?
Desrochers: I’m sorry. No, repeat that. No, because — no, it doesn’t get the same amount of money.
Now, in fairness, a bit later Desrochers says that in Jelincic’s example, Jelincic is correct, but then continues to refuse to make a general statement. Jelincic continues to try to pin him down. One private equity expert who watched this sequence remarked, “We need a Nobel prize for patience. JJ should get it!”
Jelincic uses an example where a private equity fund has an annual management fee of 100 and a 100% fee offset, so for every dollar charged to the portfolio company, the management fee is reduced by the same amount:
Jelincic: To the extent that the GP collected money from the portfolio company and shared it with the LP as an offset, then the total that the GP would have collected would have been the same. Because otherwise he could have collected 100 from the LPs. Instead he collected 50 from the LPs, gave the, the portfolio companies gave the GP the LPs’ credit for that 50, and still wound up with his 100.
Investment Director Christine Gogan: Just if you could, Mr. Jelencic, just boil down the essence of the question again and Réal and I will do our best to try to answer it from the theoretical perspective.
Jelincic: If the GP collects from the portfolio company and uses that money to offset the LPs’ management fee, so it takes it from one pocket and credits it to the other pocket, the total fees that the GP collects will be the same, assuming it’s a 100 percent offset. When you go back…you don’t agree? I mean if the assumption’s wrong…
Desrochers: No. I don’t agree.
Jelincic: If — let me give a specific. Management fee is 100. The fees to the portfolio company is 50. There is a 100 percent offset to the LPs. So what then happens is that the GP has collected 50 from the portfolio companies, and he will collect the other 50 from the LPs, because that part has not been offset. So he will have collected the 100. Correct?
Desrochers: No. He will collect 50.
Jelincic: So if he, if the management fee is 100, he collects 50 from the portfolio companies…
Desrochers: No, he offsets the management fee of 100 by the 50 million dollars that he collected from the portfolio companies.
Jelincic: OK, so he offsets 50 of the management fee. What happens to the other 50 of the management fee?
Gogan: It’s paid by the limited partners.
Jelincic: OK, so the GP ultimately gets 100. He gets 50 from the portfolio companies, 50 from the LPs. Right?
Desrochers: No.
This is just scary. Where does Desrochers think that the $50 million charged to portfolio companies in this example goes? To the tooth fairy? Or is he arguing that 50 + 50 does not equal 100? Either interpretation says he has no business having any role investing funds in private equity, much less being the person in charge.
In the words of Leon Shahinian, Desrochers’ immediate predecessor at CalPERS (emphasis his):
JJ [Jelincic] is correct in making the point that a private equity manager collects the full, contractual management fee amount via some combination of charges to portfolio companies and direct charges to the LPs through management fees. This is true regardless of what the management fee offset percentage is and regardless of how much the PE manager collects from the portfolio companies. I don’t see this as a minor point. It is a central economic feature of private equity funds that, remarkably, some LP investors do not understand, though clearly JJ does.
And from Gregg Polsky, a law professor at the University of North Carolina:
JJ Jelincic was obviously correct about the basic economics of fee offsets. The incompetence or stonewalling (take your pick) was incredible. Thank goodness there’s video.
It is not plausible that Desrochers could possibly be confused about what Jelincic was asking. Desrochers was doing everything in his power not to answer the question and to try to persuade the rest of the board that Jelincic was being unfair. There are only three possible justifications for Desrochers’ stance (and note that they are not mutually exclusive):
¶ Desrochers really does not understand how fee offsets work. If true, that would be stunning incompetence for someone at his level
¶ Desrochers does not want to admit to the board that CalPERS ultimately bears the full cost of the management fee. Desrochers has been regularly providing the board with reports on the cost efficiency of CalPERS’ investment in private equity. They are grossly misleading by virtue of omitting the portion of the management fee that is shifted to portfolio companies. An industry standard-setter, CEM Benchmarking, which has CalPERS has a client, has included this matter as one of the issues that limited partners like CalPERS need to rectify in order to report costs properly. So not only is Desrochers trying to defend the continued use of a bad metric, he is doing so in defiance of the advice of CalPERS’ own expert on this matter
¶ Desrochers does not believe that staff is accountable to the board, but that the board should have only the information that staff deems necessary and should follow the staff’s guidance. In other words, his attitude is fundamentally insubordinate. Under this theory, his efforts to stymie Jelincic weren’t as much about management fee offsets as much as a power struggle over the board’s right, indeed duty, to know
Desrochers Has Given Diversionary at Best Responses About Management Fee Offsets in the Past
The sort of response that Desrochers made at the August Investment Committee meeting is not an isolated event. See this clip from CalPERS’ December 2014 Investment Committee session:
Jelincic: One of the things that I was able to tease out is that these fees [as reported in the slide show that Desrochers just presented to the board] don’t actually represent all the money that the partners are getting. Um, for example, if the partners are getting management fees, that reduces what we pay them, that management fee issue doesn’t disappear, although it really is a cost to the program.
Desrochers: It doesn’t, it doesn’t…. The manager, the manager can collect all sort of fees. They have all kinds of fees, and it goes in cycles. There is monitoring fee, there is investment banking fee, there’s all kinds of fees they can charge. And these fees typically are shared with the limited partners. And this was today, I was, I am looking at Scott, most of them are 100% back to the LP. If you go when everybody wanted to be in private equity, the fee sharing was 50/50, 60/40. It depends, I would say it depends on the manager and it depends on where you are in the cycle. To my knowledge, we have not done any deal, and I’m looking at Scott, where the LPs don’t get 100% of the fee today, over the last two and one half years.
Jelincic: In one of the Blackstone fees, I like to pick on Blackstone because it’s one of the agreements out there on the Internet, we paid $4.3 million to them in the first year of their fund. The second year, presumably the fund was bigger because they’d put out some more commitments, but we paid only $544,000 in fees.
Desrochers: I don’t know. Because they, the fee… I will not challenge you on the numbers, and I’m happy to visit, but typically these fees are applied to reimbursement of whatever CalPERS has to pay. With Blackstone, I go back I don’t know how many years where the LP didn’t have to pay any fee because they were charging to their company and they were reimbursing the management fee.
Jelincic: So it’s likely that the reduction in what we report as fees reflects a reduction in what we paid out because they were collecting it from portfolio companies..
Desrochers: It’s possible.
Jelincic: … which ultimately we’re paying for because we own it.
Desrochers: I don’t disagree with you.
Step back to understand what happened. Jelincic raised the same issue in December with Desrochers that he did in the last Investment Committee meeting, namely that CalPERS’ staff obscures that limited partners like CalPERS ultimately pay the full amount of the management fee, as in the contractual amount, regardless of whether they make a hard dollar payment by wire or indirectly, by having some or all of the payments shifted to the portfolio companies that the investors (among them, CalPERS) own.
As you can see in a post earlier this year, in December, Jelincic’s line of questioning served to undermine a slide that Desrochers had just presented, one that sought to imply that CalPERS’ staff was doing a good job because the hard dollar management fee payments had fallen in the last year versus the previous year. Jelincic was exposing that metric as bogus. It was thus possible to see Desrochers’ hemming and hawing, and eventual nolo contendere conclusion, as a way to keep Jelincic from taking the next step of saying the slide was obviously irrelevant and staff needed to find better performance measurements.
But Jelincic posing the same question mere months later has exposed an even uglier truth: Desrochers is completely out of his league in serving as the head of CalPERS’ private equity program. He didn’t just try to evade the issue, he reversed his earlier position that Jelincic had a point and doubled down by making repeated, erroneous statements which can only confuse and misinform the board. Whether it was because Desrochers can’t grasp a simple, pervasively-used private equity technique, or that he is determined to preserve the misleading view he presents of private equity’s true cost to CalPERS, Desrochers has no business being responsible for billions of dollars of beneficiary funds.
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* The SEC and media scrutiny has focused on the fact that the limited partners assumed that all portfolio company fees were being shared, as in offset against the management fees. It turns out that only specifically enumerated fees are shared. Investors have learned, much to their embarrassment and consternation, that large fees such as termination of monitoring fees have been charged to portfolio companies and not shared as the limited partners had naively assumed.
** Jelincic actually said $180 million and $30 million, proof that Desrochers’ and Jones’ efforts to derail him had an impact.
*** If you are a glutton for punishment, you can look at this CalPERS Investment Committee meeting video starting at 1:24:20 to see what I’ve spared you.
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I had only a very, very cursory knowledge of the general, high-level structure of how PE works before looking at those videos, but I immediately understood the point that Jelincic was trying to make (which immediately raised further questions to me: how could an offset be less than 100%? The GP would then pocket even more money — at 0% offset, conceptually double the management fee…)
From the answers of Desrochers, I exclude your first interpretation (incompetence). There is actually some kind of logic in his answers: whenever Jelincic concludes that the total management fee borne by CalPERS is the sum of whatever is paid by the LP as such, and indirectly through the PC owned by the LP taking into account offsets, Desrochers says no — because he construes “management fee” to mean strictly and only the management fee directly paid by and accounted at the LP. Clearly, he is playing games with words. I presume that if Jelincic had asked about the “total fees ultimately borne by the LP, whether paid as direct management fees by the LP or as indirect fees paid by PC belonging to the LP, whatever offset arrangement is in place”, then the obfuscation would have become blatantly obvious.
The fact that the PE managers actually do not want to answer crucial questions about costs is highlighted later in the video, when Jelincic basically asks “given that a GM is profit-oriented, how come it agrees to fee-waivers, and how do these work?” Gogan eschews the issue and launches into a long explanation about the fact that all deals are audited. Then Jelincic repeats the question “How do fee waivers work?” and Gogan again skips around the issue and talks about how careful the audits are.
The clou comes when Jelincic asks whether PE arrangements are GIPS compliant (i.e. the calculation of their actual performance follows a well-established standard) — and the answer by Tollette comes: they are not…
I am at a loss for words to qualify the situation. $30B in PE and CalPERS knows neither the actual performance of its assets, nor how much it costs to manage them?
I have to tell you, to a person, none of the large number of experts on private equity that I consulted, including insiders who cannot be quoted, reads the interaction with Desrochers the way you do. They all said it is entirely possible that he really does not understand this issue, given how he kept floundering and giving inconsistent answers to what is a trivially simple question if you are in this business. One said, for instance, that:
If you’ve seen him in other board sessions, Desrochers is normally relaxed and confident when dealing with the board. Here is hesitant in handling what ought to be an easy question.
Investors clearly pay the full cost of the management fee, whether or not it comes via a direct payment or via being shifted in part to the portfolio company. Most important, in Jelincic’s 100 million, 100% fee offset question, in the part I excerpted, there is no way to defend this part:
This has nothing to do with how the payments are classified (your argument in support of Desrochers). He actually said, and more than once if you listen to that long section carefully, that the GPs don’t ultimately receive the full management fee when part is shifted to the portfolio companies. Those times, the issue was framed as what the GP ultimately gets irrespective of what pocket it comes out of (Jelincic’s metaphor). There’s no way to pretty up what Desrochers said.
So either Desrochers really does not understand this very basic point or is willing to deliberately confuse and mislead the board in order to not concede the issue that CalPERS pays the full negotiated management fee, which is not how his reports on costs present the matter. And remember, we pointed out in the post that CalPERS’ own consultant, CEM Benchmarking, has found that the way the overwhelming majority of public pension funds, including CalPERS, report private equity fund costs is out of line with GASB. CalPERS is going to have to fall into line with CEM’s push to get the industry to improve its reporting. So he also can’t claim his personal definition is correct, given that CalPERS’ expert o this matter has written a major position paper taking the opposite view.
We have more posts coming in this series, and we will examine the matter of insubordination and governance failings in depth.
I was not trying to defend or prettify the position of Desrochers. My view is that Desrochers is disingenuous, nitpicking on terminology in order to avoid answering the question about consolidated management costs — the LP pays “management fees”, whereas the portfolio company pays “monitoring fees”, or whatever they are called, and he beats around the bush from that position.
My impression is that, as you suggest, he
impression which is reinforced by Gogan twice evading the direct question about how “fee waivers” work by talking about audits instead. Consolidated PE management costs must be a supremely gory sight.
These persons might be incompetent, but after a few years dealing with PE they surely must understand the specific issue being discussed if myself, devoid of any experience or competence in PE, quickly understood it after following the interaction between Jelincic and the others.
Glad I wasn’t drinking my coffee when I read the dialogue with Jelencic, Desrouchers and Gogan. I have never seen such incompetence/obfuscation. It appears that Desrouchers can’t even add 2 + 2, (or 50 + 50), or just refuses to do so. As you say, he has no business whatsoever being in charge of any kind of investment. And he should be terminated immediately either for gross incompetence or gross insubordination.
What an education this series by Yves has been. Even I, who knew nothing about PE, can see the problems here.
The “problem” you’re seeing here is that state bureaucracy is populated with people whose sole expertise is surviving within the mileu. Longevity leads to advancement and incompetence radiates into “leadership”. And that doesn’t consider so-called Board Members whom, for the most part, are usually just cronies (with little expertise). It’s clear the CALPERS Board Chairman (who has considerable Rules of Order clout) doesn’t want incompetence and cronyism to be exposed to the public.
According to the post by Andrew Silton the video has only 65 views, how many will that be at the end of today?
Why is the focus on competence & vanity?
It’s as if it’s automatically assumed that these are honest people.The first thing I think of when encountering this type of (mis)behavior is good old fashioned corruption; kickbacks, bribes, etc.
After all, were are talking about the financial industry…
Fixed it for you :-)
CalPERS Staff Demonstrates Repeatedly That They Don’t Understand How Private Equity
FeesThieves WorkTo see such stonewalling, manipulation, and/or deception in an organization as large and well respected as Calpers is revealing about how bureaucracies operate and evolve. The inability to prevent staff (bureaucracies) from being captured by industry is apparently a widespread institutional failure. One of the reasons for having boards and committees is to create a watchdog over the bureaucracy. Instead the boards/committees assume they are getting honest and open reports and relax into a lazy euphoria rather than taking the harder route of confrontation and due diligence. Perhaps treating this as an institutional problem requiring more checks and balances is the wrong way of looking at it. Perhaps it is more like Stockholm syndrome where, over time, staff learns to identify with those who they deal with most, i.e. industry (or in this case the financial industry). Perhaps it is one aspect of human behavior where we mirror the interests of those around us in order to create a non-threatening, cooperative environment. In the case of carried interest, industry found a way of padding their profits (with lower taxes on carried interest) while simultaneously making staff look better with lower fees. The collusion was to maintain this deception that was sold to staff as a win-win. It’s not a win-win since the rest of us must make up the lost tax revenue. The deception/stonewalling is just another way to avoid the conflict between serving the interests of the board/committee/public (by making everything open to public scrutiny), and maintaining a more harmonious environment with those they deal with on a day to day basis (by maintaining the deception about carried interest). Similarly the boards and committees that provide oversight generally tend to perform this oversight it in a non-confrontational manner to make their lives easier and more cooperative – wishful blindness. Industry capture may have less to do with personal gain (though the revolving door also plays a role for some individuals) and more to do with creating a more pleasant working environment. They may actually avoid the dissonance by telling themselves that it is a white lie to avoid conflict. How to institutionally counter this aspect of human behavior may be more difficult than just ferreting out a few bad apples or lazy committee members.
Yves, thank you for continuing investigation into PE. Too many pensions are getting fleeced.
Great post!
Thanks Yves. I learned a lot from your article. Would you please point out any good resources that go over private equity? Are there any good guides available online? Thanks and keep up the good reporting!
thanks for pointing this out. shared internally and colleague says: “what a mind numbing circus.” indeed! thought i’d comment here rather than Primack, who picked this up from you.
A couple of thoughts. in addition to offsets, i think Real should have discussed the fact that the fee may have transitioned to one payable on invested capital v. committed capital…that may also accounted for a reduction in the fee amount.
Generally, i think the trustees should have understood that when you have a portfolio of funds of different vintage years, your absolute dollar amount if going to fluctuate year over year as the funds sell portfolio companies and some funds transition to based off invested capital. I know he was trying to keep it simple, but to use one fund as an example of a multiple fund portfolio does not help the trustees understand the nature of a dynamic portfolio.
It’s unclear why Desrochers was so unprepared to answer what should be relatively simple questions for an experienced private equity limited partner. However, it’s also unclear from the video and transcripts exactly what Jelincic was so worked up about in his initial line of questioning. Was it because he thinks the absolute level of fees (whatever their source) that the plan pays to its private equity managers (overall and/or on average) is too high? Or because he thinks that the plan’s investment staff are intentionally trying to hide those fees, by not recognizing that that fees paid by portfolio companies (even if offset against a fund’s management fee) also have an economic effect on the limited partner? With respect to the latter, it’s worth pointing out that to the extent a fund owns less than 100% of a portfolio company’s equity (which is typically the case, even for control investors), limited partners may come out ahead if monitoring fees paid by the underlying company are 100% offset against fund management fees.
One point on the shifting of fees from LPs to the portfolio companies in defense of the practice using a hypothetical example:
If the manager is due $100 in management fees from LPs and uses the fee offsets discussed in this article, in a hypothetical situation they might collect $50 from portfolio companies and $50 form LPs to make them whole on the $100 in management fees. From an LP perspective, this should not necessarily be viewed as equivalent to the LP paying $100.
What typically happens when a PE-backed companies get shopped for sale is that the monitoring and management fees are pro forma’d back into the adjusted EBITDA calculations, and bids are based on multiple of this adjusted EBITDA (Side note: no need to start a discussion on company valuation – this is a rule of thumb approach I saw quite often when working in PE). So let’s look at the outcome for LPs under the two scenarios:
1) NO OFFSETS: LP pays the $100 with no portfolio company fees to offset this amount. Portfolio companies get sold at some multiple of EBITDA, with EBITDA not requiring an adjustment for the monitoring fee. LP will (hopefully) make a nice return on this portfolio company. LPs pay the $100 in management fees
2) OFFSETS: LP Pays $50 and GP collects $50 in monitoring fees from portfolio company to make them whole. Portfolio company gets sold at some multiple of EBITDA; however EBITDA has been adjusted to add-back the monitoring fee (again – this is fairly standard practice…banks lending against deals will often accept this as an add-back when setting leverage covenants; Buyers will usually add this back too when running their LBO models) so that it’s sold at the same total value as in scenario 1. In this scenario, LP has paid out $50 in fees, and even though it “owns” the portfolio company that paid the management fee, there is no erosion of value when the company is sold.
The only trade-off is that this cash was not able to be used for corporate purposes (capex, debt paydown, etc.), but the ROI is likely not large enough to make up for the fact that LPs will save the $50 in cash paid to the GP without any loss in enterprise value of the company.
The GP will always be made whole, but from the LPs perspective, I see it as pareto optimal to allow for offsets because it’s keeps cash in your pocket with no penalty to portfolio company valuation.
It isn’t “pareto optimal” because the offset is limited to the amount of the management fee, plus the LPs do not get 100% offsets. CEM, which benchmarks hundreds of LPs, says it’s 85% across the industry. And CalPERS (which as we have seen is too GP friendly) even contends that this is cyclical, meaning GPs will try to roll this back if they have more bargaining leverage.
And the LPs are still paying the full amount of the fee, so who are you kidding? The “less cash from your pocket” argument is spurious. The LPs still have to allow for paying the full management fee in any period, since they have no idea what the offset will be, so they can’t make good use of the extra unexpected liquidity.
Plus all this discussion of offsets diverts attention from the elephant in the room: these portfolio companyfees are a GP abuse. Ludovic Phalippou has analyzed monitoring fee agreements and has called them “money for doing nothing”. Transaction fees are almost without exception double charging, since PE firms hire investment bankers to execute transactions. Investors should have said “no” to them long ago.
On point 1: Agree with you totally on the % offset comment. If it’s not 100%, then it’s just the GP grabbing for extra money because they can (and LPs are too spineless to push back). However, any % offset still transfers the cost of management fees to the portfolio company with no erosion of enterprise value of the company (due to add-backs), which will ultimately make it’s way back to the LP. So, even if it’s 85% sharing, a single $ of fee offset due to monitoring fees makes the LP better off than a no offset scenario. This is just math, not a logic argument.
On point 2: Even if they have to earmark the cash for the full management fees and not be able to take advantage of extra liquidity immediately, in the end they will have paid less $$ from their pocket in management fees, which can be re-deployed over time. Whether the money comes in year 1 or year 4, it’s savings. We can argue about when the money is available and its true value by applying some discount rate, but it’s definitely real money that comes back due to the offsets and at the end of a fund, the LP will not have paid the full amount of management fees versus a no offset scenario.
On point 3: Not going to argue with you there! Charging of management fees/transaction fees/monitoring fees is just another way to pump money out of these companies. PE firms get away with it because there is no impact on enterprise value. The day banks stop allowing this as an add-back in credit agreements and the rest of the PE industry stops allowing the add-back when discussing valuation, then we’ll see what happens to these fees. Until then, expect them to continue.
No, the offset does NOT make the limited partners better off. There is NO benefit to the GPs of shifting fees to portfolio companies, particularly, as the press has disclosed, these fees are too often ones that were not disclosed to the LPs and are ones the GPs do NOT offset. The whole “fee offset” regime has allowed for a series of abuses, such as “termination of monitoring fees” and “group purchasing fees” which were not subject to offsets. The overwhelming majority of GPs provide no disclosure whatsoever on what fees are being charged and how the offset is arrived at. The LPs have no audit rights and no right to see portfolio company financial. This is a recipe for cheating.
Moreover, the whole offset regime came about due to lousy negotiating by the LPs (or more accurately their attorneys who are keen not to ruffle general partners). The LPs were upset about all the fees being taken out of portfolio companies. They should have stuck to their guns and simply insisted, “Cut it out.” Instead, they allowed themselves to be talked into a regime that preserves the use of portfolio companies as GP piggy banks.
Leaving aside the question of full offset, if you had a 100% offset of management fee or portfolio company fee, there are a couple efficiencies to having a portfolio company pay a portfolio company fee.
1) It’s tax efficient. Portfolio companies are taxable entities and the portfolio company fee is typically a taxable expense while LPs are typically not taxable entities and as a result the expense would have no tax offset.
2) Opportunity cost. My understanding is that management fees are paid out of the total commitment to a PE fund. So, if you raise a $400 million fund, you might reserve $80 million in management fees (2% over 10 years). If you have portfolio companies paying that fee, more of the fund can be put to work in earning assets.
Since when is it the business of a customer to optimize the after-tax income of a vendor? Does, say, GE, which is famous for minimizing its taxes, go around to customers and say, “Gee, if you do business differently than you want to, it will lower my tax bill?” The vendor’s profitability is the vendor’s issue. The only time you routinely see buyers accommodate vendors is at the very low end, when people pay personal service staff in cash, either to help them out (acknowledging that they are underpaid) or to get a price break. Neither of those are operative with private equity general partners.
Moreover, you completely ignore the fact that even with a 100% fee offset, the fees can exceed the management fee, leaving the GP ahead. And that’s before we get to the fact that (as we have discussed at some length) that these portfolio company fees are all about rent extraction, not the provision of bona fide services.
As to your second point, no. For some funds, the GP uses a rule of thumb for the management fee and includes that in the committed amount, and in other cases, the management fees are not included in the commitment. But in either cases, your notion is off point. Retirement plan investors like CalPERS work to very long time horizons. Whether or not the management fee is defined as part of the commitment amount or not, CalPERS is contractually obligated to pay it. And in any period, it has to assume it will pay the full amount. The amount offset varies a lot, if you look at the variability over time with specific funds in the CalPERS “Fees and Costs” schedule in its Comprehensive Annual Financial Report.
Thus even if it unexpectedly winds up with extra money due to the management fees being offset, it’s not a real benefit, since it will be putting the money to work on a short-term basis, when one of the supposed merits of PE is that it commits funds over longer time periods.