LPs grow wary of fund fees

Limited partners have become increasingly concerned about which expenses general partners are charging to their funds.

The issue comes at a time when fees generally have been a focal point of discussion between the two groups, but now more LPs are including peripheral expenses like early-stage due diligence costs into the discussion, multiple industry sources speaking with PE Manager agreed.

“We look more carefully at what fees are being charged to the fund versus paid by the GP, as some GPs have clearly tried to move more costs to the fund,” said a prominent LP from a US-based university endowment.

Jason Scharfman of Corgentum Consulting, a firm that helps guide LPs through the operational due diligence process, said GPs can make the argument that the limited partnership agreement gives them discretion on what expenses are charged to the fund. “But you’ll start to see a shift where LPs want transparency on this,” he said. “They want to know exactly who’s paying for what so that more questionable expenses can be discussed.”

A typical partnership agreement states the fund will bear all costs of its operations, such as dead deal fees, outside consultant fees, taxes owed by the fund, and third-party legal and accounting services made on the fund’s behalf. But a growing chorus of LPs are questioning which items can be fairly considered fund expenses.

“What has changed, I think, is that LPs are balking at the funds paying for private planes and sometimes first-class travel,” said one US-based fund formation lawyer. A related example he gave has to do with executives who own private jets used for both business and personal travel. “How should costs [related to owning] the plane be allocated?” the lawyer said, noting those were the sorts of issues LPs were asking about.

According to one source, expensing such fees has been long common practice for some private equity firms. “Do they take advantage of it? Of course,” he said. “I think you would be shocked.” Increased scrutiny from the US Securities Exchange Commission in the form of audits, he added, now have certain GPs concerned about what, in some cases, has been standard practice going back many years. “The GPs are losing sleep at night,” the source said. “They’ve never been audited before. Now they are.”

Investors, meanwhile, are increasingly concerned about what types of expenses are being charged to a fund without full disclosure. “They can easily bury these outsourcing costs in the financial statement,” said a fund of funds executive. “It isn’t an itemized expense report.”

The fund of funds manager went on to say he was suspicious of firms with billions of assets under management that, for example, never hired a general counsel to handle various legal services. “A general counsel could handle forms like Form ADV if they are SEC-registered. But if you don’t have that in-house lawyer, are we paying for that [to be outsourced]?”

One chief financial officer of a major private equity firm said GPs should not just consider what the partnership agreement allows, but what makes sense from an investor relations standpoint as well. Using the same Form ADV example, the CFO said he and his partners, which do not have a general counsel in-house, felt the right decision was to charge that reporting expense to the management firm, not the fund.

Graham Winfrey contributed to this report.