Deal or no deal: Who pays when an investment fails

Few areas of the LP-GP relationship are as thorny as the allocation of costs resulting from broken deals. It goes without saying that paying for investments that fail to materialize is a bitter pill to swallow. Indeed, controversy surrounding the allocation of fees and expenses related to broken deals has continued to rumble on, even as other areas of contention are resolved. Firms to have fallen foul of broken-deal fee violations famously include KKR and, more recently, Platinum Equity Advisors.

That said, there is a clear direction of travel, with 66 percent of respondents to the survey this year stating they charge all broken deal expenses to the fund, down steadily from 79 percent in 2018 and 85 percent two years earlier. However, PEF Services CEO Anne Anquillare says this shift is not without its challenges: “Where broken-deal costs are not considered fund expenses, you could get into the situation where the manager isn’t spending enough on due diligence or else doesn’t want to pull out of a bad deal.”

Blue Wolf Capital CFO and CCO Joshua Cherry-Seto also rejects the idea that the fund bearing the cost hurts alignment. “This is a negotiated item, which is a cost of doing business, but LPs may feel that there is not enough alignment to sufficiently control the cost unless there is more skin in the game for the GP,” he says.

“However, there is a significant commitment of the GP in the fund and all GPs expect their funds to exceed the hurdle, in which case, 20 percent of any excess expense is effectively borne by the GP in foregone carry, so it is actually highly costly.”

Saw Mill Capital CFO Blinn Cirella, however, believes that resistance to LPs bearing broken-deal costs is more of an emotional one.

“My guess is that it has to do with the cost of travel – with GPs frequently flying on private jets,” she says. “In an LP’s mind, this should be what the management fee covers, as it’s a routine part of doing business. Our first fund did not allow for travel related to broken deals to be passed through to the fund – only legal, consulting and finder’s fees. The definition of broken deal costs is important.”

Meanwhile, the proportion of managers that allocate all proceeds from broken deals, for example, termination fees, to the fund, ekes upwards, albeit from a low base. In 2016, just 4 percent of managers considered this usual practice, compared with 5 percent in 2018 and 6 percent this year. But not everyone is a fan of the trend.

“When I started at Saw Mill in 2006, the fees collected from portfolio companies were shared 50/50 with LPs,” says Cirella.

“Over time, LPs have demanded a great share. Our second fund, the share was 80 percent to the LP and newer funds are 100 percent. Why bother with the fee if you can’t keep a portion of it?”

There has also been a marked decrease in the use of ancillary fees, such as monitoring fees, which are known to have particularly riled the regulators – and LPs. In 2018, 35 percent of managers surveyed did not make use of monitoring fees at all. That has risen to over half this year.

Financing fees are also on the decline, now used by only 42 percent of managers compared with 57 percent two years earlier, with just under a quarter of those that do employ the mechanism offsetting it completely. Furthermore, just 51 percent of managers still charge closing fees, with 30 percent completely offsetting them, compared with 64 percent charging closing fees and 44 percent completely offsetting in 2018.

“The market is demanding 100 percent offset as firms grow and mature, which means the reduction in the use of these fees certainly makes sense,” says Cherry-Seto. “However, it still pays for GPs to charge these fees, as they reduce the J-curve by reducing early checks written directly by LPs. In addition, the fund usually has a higher percentage of fees from an investment than their equity interest in the company, and so earns more through fees than equity.”