Would you like some co-invest with that?

How absolute is the primacy of fee income in private equity? Here’s one indication: this steady source of revenue – once meant to “keep the lights on” until the carried interest arrived – figures prominently in the business plans of IPO-bound private equity firms. GPs are now selling their franchises to shareholders based in part on discounted cash flows from that world without end called management fees.
Take, for example, a slide from the investor presentation Kohlberg Kravis Roberts released last month to explain its proposed acquisition of the Euronext-listed KKR Private Equity Investors (KPE).
“The combination of KKR with KPE provides KPE unitholders an opportunity to participate in all the economics of KKR’s business” including transaction fees, monitoring fees, carry, and on the top of the list, management fees.
But is the current market range for management fees set in stone?
Taking the old saw about the “pendulum of power” at face value, with the proverbial pendulum swinging toward LPs in bad times and back to GPs in good times, the last private equity downturn arguably gave LPs the gumption to push for some better terms, but lower management fees was not among these.
This (bad) time around it would appear that GPs at large firms are willing negotiate around the sacred management fee without actually having to change any numbers in the partnership docs. In so doing they are exploiting an LP desire that may be even more fervent than the desire for lower management fees – the desire to co-invest.
According to the head of a major fund of funds firm, he has been approached by several large buyout firms in fundraising mode with an intriguing offer – make a commitment to our next fund and we’ll throw in several co-investment interests from our current fund. In other words, the GPs are willing sell down the fund’s direct ownership in portfolio companies to their LPs. This, of course, has the effect of lowering participating LPs’ management fees in the existing fund because management of the assets in question technically transfer out of the partnership and into the LPs’ directs bucket.
In effect, these solicitous GPs are hoping to trade in some of their current management fee income in order to secure more future fee income. Clearly GPs in fundraising mode are anxious to close their next funds and mindful of the perfect storm of shrinking denominators and trickling distributions. For IPO-bound GPs, there is even more at stake – if a big private equity firm can’t keep up its pace of fundraising, it can’t convince public shareholders that they are buying into an ever-expanding empire, and the valuation plummets.
Is there any other industry where the biggest customers don’t eventually get a volume discount? The increasing support of the biggest LPs is crucial to the future of private equity, setting aside dreams of “permanent” capital vehicles. Having raised as much as humanly possible during boom times with full fee terms, big buyout firms are finding that, amid leaner times, they are having to offer exciting incentives or risk a precipitous plunge in fundraising numbers.
In these uncertain times, no firm has gone to greater lengths to appease its customers than The Carlyle Group, a global alternative investment machine fueled by an unceasing flow of LP capital commitments. An LP source says that Carlyle has gone well out of its way to appease those investors harmed by the collapse of Carlyle Capital Corporation, the short-lived credit vehicle. In the broader scheme of things it wasn’t a lot of money down the drain, but Carlyle took a reputation hit. According to the source, Carlyle has offered the investors in Carlyle Capital fee-free access to any next Carlyle fund of their choosing. (Carlyle declined to comment and did not confirm or deny the information).
This is the high-finance equivalent of offering your diner a discount on the main course because he found a fly in his soup (but he still has to pay for the soup).
These fee breaks may be temporary incentives until the pendulum comes swinging back the GPs’ way. More worryingly for GPs, they may instead set in motion an irreversible step down for standard management fees.