Deal fee dilemma

Under increasing pressure from LPs to reduce management fees, some private equity firms seem to be jacking up deal fees to compensate.

A struggling household’s breadwinner might consider a second job, or perhaps some overtime, to generate the supplementary income required to keep the lights on. Apparently, it’s a similar story for private equity managers as they find themselves under increasing pressure to dial back management fees – the (typically one percent) charge on investors’ committed capital supposedly used to finance fund operations. 

Faced with a downturn in management fees, some firms seem to be trying to compensate by increasing fees charged to their portfolio companies. According to a new study led by Dechert, a law firm, during 2009-2010 (the period when LPs started ramping up the pressure on fund charges) transaction fees shot up relative to years immediately before the crisis. GPs operating in the $500 million to $1 billion deal range, for instance, collected on average a 1.24 percent transaction fee for deals done in 2009-2010 – a noticeably higher figure than the 0.99 percent average charge between 2005 and 2008. Similarly monitoring fees, which GPs bill companies for ongoing advisory services, have also climbed since 2009. 

Of course, it is impossible to know for sure whether firms are deliberately increasing deal fees in response to LP demands for reduced management fees. But it is not inconceivable, especially considering performance fees (or carried interest) are no longer as much of a given as they were during the industry’s boom years. 

Furthermore investors may see less risk and more reward in this approach, since they reap a greater share of deal fees. As we reported earlier this year, LPs are winning greater concessions from fund managers on transaction and monitoring fees. 

But if investors are grabbing a bigger slice of the pie, GPs have an incentive to charge higher deal fees, just to maintain their income levels. And the risk is that this approach may result in a disgruntled management team at the portfolio company level. For obvious reasons, no business wants to feel that it’s being milked by its financial sponsors. Ramping up deal fees may not only be damaging to that particular company’s balance sheet; it could also leave future targets wary of a particular GP’s brand of management.   

If fixed revenue streams do start to dwindle, some GPs may find themselves needing to shutter offices, reduce headcount or trim overheads to keep running costs down. But milking portfolio companies for higher fees to balance the books is surely not a sensible long-term strategy.