Managing the deal tab

Private equity is unquestionably a pay-for-performance industry, with general partners' compensation tied directly to the returns they reap (or don't reap) for investors. With many of today's private equity-backed transactions containing complexities to be grappled with – be they deals involving cross-border considerations, highly-regulated sectors or distressed targets – GPs are now more reliant than ever on the solid counsel of both in-house and external advisors to help them achieve what they said were their stated objectives.

Quality advice, therefore, is highly sought after by GPs. Particularly in the realm of evaluating and executing deals, the booming demand for high quality expertise is propelling prices for legal, accounting and other advisory services up – not quite to the stratosphere, but often to dizzying heights.

Still, private equity firms need not be overwhelmed by waves of invoices from their service providers. While the quality of service is still paramount, honing a well thoughtout strategy to managing deal expenses can help keep costs under control and vendors happy.

Runaway costs
“There's no question that deal expenses have skyrocketed in recent years,” says Mark Tresnowski, managing director and general counsel of Madison Dearborn Partners, a Chicago-based buyout firm.

He points out that the legal fees charged by top tier firms now range roughly between $500 and $700 per hour – often with a 15 percent premium charged for legal services in Europe (roughly €460 to €640 per hour). In addition to the steep hourly rate, the amount of time that external legal counsel spend on each deal has also been drawn out, given the complex nature of transactions.

At the same time, says Tresnowski, the combined effects of Sarbanes Oxley and the decrease in the number of large accounting firms means that prices for accounting services have been on the rise as well. GPs often face hourly rates for accounting services at or exceeding the $1000 per hour level.

Overall, legal fees take up, by far, the greatest chunk of expenses incurred from evaluating and executing a potential investment, according to the chief administrative officer of a New York-based investment firm. The next two largest line items on a deal tab will tend to be accounting expenses and the cost of insurance and risk management. In a typical deal, if the accounting costs from the transaction are X and the insurance costs are Y, then legal expenses can easily come in at two times the sum of X and Y, notes the CAO.

In the case of due diligence and negotiation efforts that result in the closing of a deal, the key consideration becomes negotiating the timing of payment with vendors, especially if the deal takes a long time to close. “Fees usually get backed into the transaction and capitalized through the portfolio company,” says Christopher Giordano, a partner at the New York office of Winston & Strawn law firm, adding that he has not come across instances where the deal-related expenses are charged back to either the GP or the LP for acquisitions that are successfully executed.

The big issue is when a deal “dies,” leaving the GP to handle the expenses of a broken deal. In the current competitive market for deal flow, private equity firms are increasing participating in auctions, with many GPs finding that in order to be considered a credible bidder, it helps to be able to say that they've already done the due diligence. One of the consequences has been that a higher volume of broken deal expenses is now considered regular cost of business.

Some GPs that previously paid broken deal fees out of the management fees are now finding that, because of the increased frequency of broken deals, it's no longer realistic to shoulder the burden in that manner, and that they now have to engage in the painful process of charging broken deal fees to their LPs.

Therefore, minimizing broken deal expenses – without compromising the quality of a GP's investing activities – has become an important issue for many private equity firms. In grappling with these expenses, GPs have the option of pursuing options that are both internal and external to the firm.

In-house solutions
The topic of establishing in-house cost control mechanisms is increasingly a front of mind topic for private equity firms, particularly in light of the growing size of broken deal expenses. On the one hand, GPs don't want to miss out on great deals that involve a substantial amount of upfront costs to pursue. On the other hand, a private equity firm is after all a business, with a need to manage its expenditures and balance them with the incoming cash flow.

Tresnowski notes that Madison Dearborn has several milestones marking the path of pursuing a deal, providing guidance on the level of cost to be incurred and the approval – for example, by the MDP investment committee – that is required.

Having clear guidelines on how much to spend (as well as when to spend and who has to approve the spending) when chasing down a deal can help reinforce the lines of communication between the investment side and the operations side of a private equity business. “I think it takes a very active participant on the operations side of the firm – say, the COO or CFO – to actively monitor the costs as they're occurring,” notes the New York-based midmarket firm's chief administrative officer.

Another internal mechanism that some GPs have adopted is generating a “dead deal list” at regular intervals. Such a list – compiled perhaps on a quarterly basis – can provide data on which deals didn't go through, who sourced those deals and how much was spent pursuing those deals. Few investment professionals would like to see their names attached to a long list of dead deals, especially if it should have been fairly clear to them early on – before significant expenditure was made in chasing the deal – that those deals were a very long shot.

External relationships
Apart from setting up such internal protocols for tracking expenses, private equity firms also need to manage their relationships with several outside parties and monitor their status with regards to their vendors.

Fees are, in large part, driven by the relationship between the counsel and the client. This goes for both the level of fees, the timing for paying the fees, as well as potential offsets for fees.

At 3i, a London Stock Exchange-listed global private equity firm, the firm relies on private, preferred suppliers for conducting due diligence, and the firm's in-house professionals are trained to manage those relationships. “Training is key – that is, training professionals to manage costs, to have a clear budget and to manage intermediaries in the right way,” says Patrick Dunne, 3i's group communications director. “We monitor and track what services cost quite carefully, so we know what we're paying at that level. Performance is measured as well, especially in the due diligence area.”

To manage vendor relationships, an increasing number of GPs are bringing on board in-house expertise, particularly at larger firms and at firms with substantial dealings with the public or other highly regulated markets. Very often, this expertise is in the form of in-house general counsel.

According to MDP's Tresnowski, bringing on an in-house general counsel is a relatively recent phenomenon among private equity firms. For firms that do have an in-house legal advisor, that person tends to play an administrative role (i.e., drafting and reviewing contracts and documents), a transaction advisory role (i.e., reviewing prospective investments for possible legal implications) or a combination of both.

On top of that, “one of the important roles that such inhouse legal advisors can play is to manage costs by directing outside lawyers,” says Tresnowski. Particularly as private equity shops grow larger and as some begin diversifying their businesses to look more like asset management companies, it is critical to have a pointperson in place who is familiar with all of the GP's vendor relationships and needs.

For GPs active in the smaller end of the US middle market, many of these firms do not have in-house general counsel. On matters like fees, Winston Strawn's Giordano says he typically deals with the investment professional and the partner who is more senior at the firm.

Another consideration is whether to source advisory services from a single source, or to diversify to two or more vendors.

“It's not necessarily about the cheapest cost but the highest value,” says Dunne. “The language we use within our own company is having the culture of the best team for the job. When we construct a team, we decide who should be in that team – both internally and externally – based on a process of assessing who's going to be the most valuable to that team.”

Due to the scale of the firm, 3i has a wide network for knowing how much certain services cost, and the various branches and divisions of the firm share knowledge on which service provider is the right firm for the particular country or particular sector in question, says Dunne. Therefore, the firm is comfortable with and capable of sourcing its advisory services from multiple vendors around the world.

Other firms prefer to stick with one main law firm that serves as the firms' general counsel. Apart from certain instances – such as in consortium acquisition deals – these firms try whenever possible to use their general counsel to do the M&A work in a deal.

“We have our general counsel – regardless of whether or not they are the M&A counsel – look at the transaction to make sure there's nothing LP-adverse in the deal,” says the midmarket firm's CAO. “Sometimes the M&A counsel, if it's not our general counsel, doesn't know all of the tweaks of our LP structure. Our general counsel would know all the things to look at.”

Having one's tax counsel look over the deal documents to make sure everything is in line on the finance side is also helpful for peace of mind that LPs are protected down the road, says the chief administrative officer.

In terms of managing the timing of payments, “High service legal and accounting firms are open to receiving payment for broken deals when capital is next called from LPs, as they are familiar with private equity firm cash flows,” says the CAO.

“As a service provider, part of the service is working with the client to work out a mutually advantageous payment arrangement,” says Giordano. “It all depends on the client, the circumstance and a number of factors that are nebulous.”

As with most aspects of the private equity realm, what managing deal expenses boils down to is managing your relationships – internally with the deal team, and externally with service providers and, in some cases, with co-investors.

Club etiquette
Given the current seller's market, GPs are often partnering up with other firms to make bids for acquisition targets. In deals where a consortium of buyers is involved, there isn't really one answer to how the group should choose its advisors, says Madison Dearborn's Mark Tresnowski.

In many cases, if one of the sponsors takes on the role of de facto lead, then the deal counsel will tend to be the counsel chosen by the lead, says Chris Giordano of Winston & Strawn.

However, notes Tresnowski, the group should consider whether certain members of the consortium have unique relationships, leverage and discounts with certain vendors.

No matter which consortium member gets to choose the M&A transaction advisor, each member of the club will also have its own counsel looking out for its particular interests. In Giordano's experience in the lower middle market, if one GP is leading a transaction and there are two other co-investors, the expense for the counsel of the two co-investors is typically borne by those co-investors, while the expense for the main transaction lawyer is run through the portfolio company.

And in the case of club efforts for deals that wither on the vine? At least the GPs can take comfort in being able to share the broken deal fees among the members of the club, says Tresnowski.