The work before the work

The challenge:

It’s complicated work setting the firm’s annual budget. So how exactly should the CFO prepare? What needs to be considered to map out the firm’s financial year?

Joshua Cherry-Seto’s answer:

A private equity manager’s budget is first and foremost about cashflow rather than a traditional profit and loss (P&L) budget. The manager is generally organized to be cash neutral rather than profit maximizing, where ultimately if you boil it down, you endeavor to match revenues with compensation – all the rest, though still important, is not where the heavy mental lifting occurs.

The biggest challenge of budgeting in the private equity space I think, and probably the most interesting, is figuring out how you manage the volatility and timing of deals and how cashflow is impacted by the deals, their fees, and management offsets articulated in your limited partnership agreement (LPA).

Though the fund management fee base is seemingly fixed during the investment period when it is standard to be on the basis of commitments from investors in the fund, there are numerous issues and offsets which are far from standard and can significantly impact your cashflow. This includes expectations and offset treatment of transaction and monitoring fees as well as other management fee offsets such as placement agent fees and deemed contributions making the timing of deals of vital importance.

On the deal side, you might broadly say the expected pace of investment for the first three years will be four, normally sized and averagely structured deals a year, one each quarter. However, closing deals is a zero sum game with each deal potentially looking vastly different, so that might mean three small deals in the first quarter and nothing for the next 12 months. This means the first partner driven parameter a chief financial officer must ask is ‘how much cash flexibility does the management company have? If you pass a lean period, are the partners willing and able to fund the operating shortfalls? Do you have access to a management company line, and how much stress can it handle?’ Your budget should include a reasonable stressed revenue projection to present to your partners.

In general, the extent to how much the volatility of your deals matters depends on how you have handled in your LPA your transaction and monitoring fees. How much to expect for these, and how dependent is your budget on their regularity? The cash is available to spend, but there will be a budgetary reckoning as we all have a management fee offset, which is usually between 65 to 100 percent.

This can be compounded by your deemed contributions program. Deemed contributions are the management participation interests where the investors are contributing part of your GP interest in the fund in exchange for reduced management fees in the future. This is a direct compensation benefit to employees in the GP since they get this portion of their investment contributed on their behalf. How firms treat this benefit, as the amount is deducted from fund management fees, varies widely. If like in our firm, there is no offset to compensation then this is a pure and unadulterated drag on your revenue stream, because I pay you what I think you are worth and then on top of that I’m going to give you access to the deemed program which lowers the management company fee income. This drag is generally mitigated by some reduction in the bonus pool, but depending on your pace of investment, you may be accruing rapidly an additional management fee offset I owe you. Note, that though ultimately senior partner compensation is driven by future carried interest, the ongoing compensation, including bonus expectations, are not generally deferred even if the pace of investments is slower than expected.

In addition, placement agent fees also materially impact the management fee base early in the fund’s life. These are generally paid over the first eight to 12 quarters, and can be as much as 50 percent of management fees during that period, assuring that you will not have enough management fees to cover all your offsets. So you are digging this hole of receiving cash through portfolio company fees, spending it on your bills, though a portion of it isn’t technically yours because you need to credit it back to the investors in the future. However, since you don’t have enough management fees to credit it back immediately, you run a negative balance that can become quite substantial. So maybe after your placement fees run off in two years you start to have a little room in your management fee so you can begin to chip away at this multimillion dollar hole that you dug.

So early in the fund you are collecting cash for transactions, but by year three you are no longer getting these fees because you have done your acquisitions and are still far from making your exits. Your cash flow goes down but your management fees don’t come back up because you have got this deferred amount that you need to credit back to your investors, so you could have multiple quarters of no management fees and only monitoring fees from your portfolio company, so you could actually see a significant dip in available cash even if you are investing along the path that you anticipated.

Therefore, for us in the private equity space, successfully managing the budgeting process is driven by understanding your deal trajectory, how your LPA treats transaction and monitoring fees and other offsets, how compensation is or is not effected by fund activity, and how much cash flexibility, if any, you have through your partners or a management line. The LPA is usually drafted by lawyers, so get in the conversations early as they will dictate much about your budget, and equally engage your partners about the expected volatility in cash flows which could be mitigated by flexing compensation somewhat according to investing and securing in advance personal partner commitments in cash and financing.