Feature: Budget under review

Picture if you will, a private equity firm’s chief financial officer sitting down with a group of curious investors to discuss budget work. Strewn across the meeting room table are budget projections, expense reports and even the salary figure of the secretary who had just moments prior led the morning visitors to meet the anxious CFO, a reserved individual clearly unaccustomed to sharing such sensitive matters with outsiders. 

It’s certainly not an everyday scene in the industry, but some variation of it is not unprecedented. A new spin-out has recently been shopping itself to potential limited partners by stressing it will charge management fees based on budget figures rather than fund size. The hope is it will win favour with fee-wary LPs and shorten the marketing period for its debut fund, according to one LP source who declined to provide further details on the fundraise. In recent interviews with PE Manager other LPs too have noted seeing similar setups cropping up in the industry.  

WHAT LPs ARE SAYING

In all LPs stress that management fees were originally intended to help “keep the lights on”, or pay salaries and basic operating expenses while the firm waits for carry to roll in. However as fund sizes have grown, the 2-and-20 model has remained largely the same, meaning management fees – in some cases – have turned into a stable, continual source of revenue regardless of manager performance. It also creates incentives for managers to keep raising larger funds.

“It really takes little more money to run a $3 billion fund than a $2 billion fund – let alone a series of overlapping funds,” confirms one emerging markets-focused GP.   

A recent venture capital study published by long-time LP the Kauffman Foundation makes a similar point, arguing a better option than a flat 2 percent management fee is the budget-based charge, which “offers better alignment between GPs and LPs, gives GPs sufficient capital to operate their firm, and provides LPs with transparency into firm economics”. 

Despite these concerns most GPs have not been forced to fully reveal their hand with respect to budget costs – however at the same time more LPs are now requesting that they do.  

A current middle ground appears to have been reached, at least in some circumstances, says David Fann, head of LP advisory firm TorreyCove Capital Partners. “We always ask GPs for a copy of the budget. But what we usually get in return is an overview of the firm’s financials and business economics.”

A separate LP source speaking on the condition of anonymity agreed budget requests were being made, but that “very few GPs will actually provide them”. The LP added that for those GPs that do, it is usually presented in summary form, and crafted in a way that implies the firm is making very little money off of fees. “But there is no way for us to validate that without giving us the financial statement.”

WHAT GPs ARE SAYING

A significant number of private equity firms, and more directly the CFOs themselves, were invited to comment for this article on the concept of a budget-based fee model. The vast majority declined comment – a response perhaps underscoring the sensitivity of the subject. Or it may be the case that GPs see little benefit at all in entertaining the idea of an openly shared budget. GPs may feel naked with this level of transparency, or perhaps predict that allowing the subject to become a two-sided conversation would only lead to further reductions in already heavily negotiated management fees. 

Then again an open conversation on operating expenses could be the perfect opportunity to show investors why management fees are where they are, says one US-based chief financial officer of a mid-market private equity firm. 

“We’re about to enter the fundraising cycle and we plan to show our investors  how much money drops out of our bottom line with further fee cuts. And then when they see that big negative number, we’ll ask ‘How do you expect us to generate returns for you?’”. 

Moreover an interesting psychological dimension to fee negotiations and sharing budget information relates to differences in compensation between LPs and fund managers, notes the CFO. A public pension employee barely pulling in six figures a year may not be sympathetic to the argument that GPs risk losing top talent to competing firms or industries if salaries are reduced from very rich to just rich. And so whether justifiable or not, an open discussion on budget expenses (and thus salary packages) results in some unavoidable frictions between professionals within different income brackets. 

The CFO went on to say the compression on management fees is leading GPs to become more creative in how they finance their operations. One option has been for GPs to take operating partners off their payrolls and rehire them as outside consultants so that their salary expenses would instead be borne by the portfolio companies benefiting from their services. “The downside of that is you can’t guarantee their availability. Their work will go to the highest bidder.”   

Faced with a downturn in management fees, some firms seem to be trying to compensate by increasing fees charged to their portfolio companies. According to a study released late last year by Dechert, a law firm, transaction fees shot up relative to years immediately before the 2008 banking meltdown. GPs operating in the $500 million to $1 billion deal range, for instance, collected on average a 1.24 percent transaction fee for deals done in 2009-2010 – a noticeably higher figure than the 0.99 percent average charge between 2005 and 2008. Similarly monitoring fees, which GPs bill companies for ongoing advisory services, have also climbed since 2009, according to Dechert. 

Of course, it is impossible to know for sure whether GPs are deliberately increasing deal fees as a supplementary source of income in response to management fee concessions, but if so, it may only be a temporary solution. Guided by ILPA guidelines, a key priority for investors today is 100 percent of transaction fees to offset management fees – a departure from the typical 50 to 80 percent figure used in the past. 

“What I’m seeing in the LP community is they follow 100/0 fee sharing religiously, and don’t necessarily look at the budget and understand why a GP may need that fee income to cover overhead costs,” says the anonymous CFO. One New York-based funds formation lawyer notes that deal fees also often finance junior dealmakers annual bonuses. Without it, says the lawyer, retaining talent becomes more difficult for GPs. 

In response to criticisms that ILPA’s guidelines are encouraging investors to adopt a rigid approach during fee negotiations, ILPA executive director Kathy Jeramaz-Larson said the group’s principles were simply meant as “a set of best practices and used in conversations between GPs and LPs”. On the matter of all deal fees being returned to the fund, Jeramaz-Larson argued it was a matter of aligning interests “between GPs and LPs for the benefit of all constituents”.

The CFO responded to ILPA’s defense saying that the “starting point has become religion for many investors” and that carried interest represents the “true alignment of interest”. He went on to suggest LPs enter into ad-hoc relationships with fund managers, and avoid drawing lines in the sand around transaction and management fees. “LPs should reject any one size fits all approach and simply focus their efforts on finding the best returns.”
If that approach were taken, it would seem, a sit down with investors to discuss budget expenses may not be so uncomfortable after all.