There is no doubt the combination of a punishing Securities and Exchange Commission crackdown in the wake of the financial crisis, together with LPs finally finding a common voice in ILPA, has led to a tightening of practices and procedures around the issue of private equity fees and expenses.
What began with the Dodd-Frank Act and the creation of a specialist Asset Management Enforcement Division at the SEC a decade ago led to headline-grabbing multi-million-dollar settlements with private equity giants before driving opacity out of the asset class and resolving controversial issues about who pays for what. And yet, SEC sanctions persist and tensions between investors and managers remain. It is clear there is still some way to go. Conducted biennially since 2014, the Private Funds CFO Fees & Expenses Survey has captured these shifts in the GP/LP relationship. Here are the most important developments identified this year.
On a need to know basis
There has been a fall in the proportion of managers that would automatically disclose details of deficiencies from an SEC examination report to LPs. Over a third say they would always share the information, but 29 percent would only do so if forced to by individual agreements with investors and 13 percent would avoid doing so at all costs. “Managers don’t want their LPs to have that information, so they resist disclosure,” says Julia Corelli, partner at Troutman Pepper. “LPs, meanwhile, are pushing for transparency and so we end up with side letters.”
The proportion of managers charging all broken-deal expenses to the fund has been steadily declining – from 85 percent in 2016, to 79 percent in 2018 and 66 percent this year. The shift is not without its critics, however, who cite potential pressure on GPs to cut back on due diligence or push on with a sub-optimal deal. Meanwhile, the proportion of managers allocating all proceeds from broken deals to LPs is edging slowly upward. But don’t expect to see any significant leap anytime soon. “Why bother with the fee if you can’t keep a portion of it?” asks Blinn Cirella, CFO at Saw Mill Capital.
Out of favor
There has been a marked decline in the number of firms utilizing supplementary fees, such as monitoring fees, financing fees and closing fees. Where these fees are employed, they are largely offset. ILPA’s director of standards and best practices Neal Prunier, says this is a welcome result of LP pressure. “These practices have largely fallen by the wayside,” says PEF Service’s CEO Anne Anquillare. “This is a perfect example of how the market has shifted towards a more acceptable state for investors and regulatory agents. For the most part, this hasn’t resulted in a loss of capital for firms and so they have been happy to acquiesce.”
Almost half of managers surveyed have made changes to their valuation policies as a direct result of SEC intervention – an increase of 7 percent on 2018, and a reflection of the priority that the SEC is placing on valuation methodologies. However, the proportion of managers surveyed that have made changes to their LPAs following an examination has actually fallen. This is likely to reflect progress that has already been made, as the level of detail included within the LPA continues to grow.
More trouble than it’s worth
The proportion of managers offering co-investment has fallen from 87 percent two years ago to just 75 percent. This drop has taken place against ongoing appetite for co-investment from LPs, according to ILPA’s Prunier. One possible explanation is that SEC scrutiny of transparency and fairness surrounding co-investment has made the practice unworkable for some GPs. “It may have become more trouble than it is worth,” says practice leader at Withum’s Financial Services Group Tom Angell.
When to keep things in-house
According to our 2020 survey, outsourcing is becoming increasingly common, particularly in areas such as fund administration, where pressure from LPs and regulators, and increasingly complex operational needs, has led to a growing number of firms favoring an independent set of eyes. One area where the trend has been reversed, however, is around valuations, which are steadily being brought back in-house. “This reflects the fact that the LPAC is increasingly being relied upon to approve changes to valuation methodologies in the wake of SEC scrutiny,” says Corelli.
No more double charging
There has also been a significant move from managers routinely charging management fees from first close – dropping from 51 percent in 2018, to 24 percent this year. LPs are pushing back on fees for a fund that has not yet begun investing, with 37 percent of managers now introducing the management fee on the first capital call. Equally, there has been an increase in managers tying the fee of the new fund to a step down in management fee at its predecessor.
Over a quarter of managers have made no provisions for how management fees will be adjusted in the event of a fund extension. And yet, the significant market dislocation created by covid-19 means these extensions are likely to be increasingly in demand. And, while Corelli says the rule of thumb is that anything not provided for in the LPA will be borne by the management company, 10 percent of respondents expect to be able to negotiate no change to fees as and when such negotiations take place.