The name game

When GPs charge monitoring fees to portfolio companies for ongoing management and advisory services – often allowing them to offset the overall management fee – the portfolio company can write off the payments as tax deductible business expenses. But are they really a dividend, meaning they should be taxed? Recent commentary in the pages of Fortune and The Wall Street Journal argue that the terms of these fees indicate they be should be treated as such, leading to industry concern.

 

Indeed, many industry CFOs pfm reached out to said they didn’t feel comfortable talking about the issue, but admitted they were paying close attention, since the fees represent a significant revenue source. And few lawyers or auditors wanted to go on the record about the tax treatment of monitoring fees, admitting the Internal Revenue Service (IRS) was currently challenging their clients on this very matter.

 

Critics of the practice contend that the fees aren’t actually compensatory in nature since the fund manager isn’t required to provide any specific service for those fees, and can terminate the contract at will, while still being paid for the full term of that contract. Furthermore, in consortium deals, the fees are split on a pro rata basis, further casting the fees as really a dividend to the fund. However, while the IRS is challenging the deductibility of these fees, it has not issued any guidance on the matter or demanded any monitoring fees be recast as a dividend… at least not yet.

 

Experts suggest that as the IRS continues to learn about private equity as an asset class, GPs can make a compelling case to tax authorities that monitoring fees should not be treated as dividends. That case rests on three points: first, the fees are paid directly to the GP, not the fund; second, that the fees are paid to the GP for services that benefit the portfolio company more directly than the fund; and lastly, and most importantly, the GP provides real value for the fees, with services that may be broadly defined but nonetheless valuable enough to be compensated for, even if the contract ends prematurely.

 

According to current US tax law, monitoring fees must meet two criteria to be considered deductible by the portfolio company: one, the fees must seem reasonable in terms of services rendered, and two, they must have “compensatory intent.”

 

Given how many private equity firms tout their operational expertise in creating value at their portfolio companies, it’s easy to see how GPs can meet the first criteria. But the way these fees are structured contractually can undermine their “compensatory intent.” It’s often noted by critics that while the amount of fees a portfolio company owes a GP is spelled out definitely, what the GP owes the portfolio company is not.

 

One of the chief critics of these fees as a deductible expense is a tax professor from the University of North Carolina, Gregg Polsky, who has written several critiques of the practice. He’s also the attorney for an IRS whistleblower in a case that argues these fees should be treated as dividends. Polsky believes the contracts for these fees prove they fall well short of compensatory intent. “According to these agreements, the managers aren’t required to do anything in exchange for these fees,” says Polsky. “And they get paid the full value of the contract even if it is prematurely terminated. In some cases, they get to cancel these contracts at will and still get paid in full.”

 

Among the many “management services” agreements Polsky references is the case of the retailer J.Crew, an investment led by TPG. In the agreement, J.Crew owed TPG and Leonard Green, its minority partner, a total of $8 million in fees, but the agreement could be terminated at “any time” by the “Manager,” while all unpaid fees would still be due. Similarly, in the advisory agreement with sensor and control supplier Sensata, Bain Capital was owed fees for a ten-year period, regardless when the contract is terminated. Some industry participants argue these fees are the equivalent of retainer fees for lawyers, but few law firms can negotiate fees for the years after they stop providing counsel to that client.

 

Perhaps the best argument that these fees should be treated as dividends is that the fees are divvied among GPs in a consortium according to their ownership stakes. In TPG’s J.Crew agreement, it reads, “The amounts described in clause (ii) above shall be divided among the Managers in accordance with the Managers’ Relative Interests.”

 

A particularly egregious example often cited by critics is the fees agreement for the GNC investment by Ares Management and the Ontario Teachers’ Pension Plan. Ares Management received income amounting $750,000 annually, while OTPP received a “special dividend” for that same amount. If the compensation can be called both income and a dividend, why can’t it be considered a dividend all the time?

 

Should the IRS question if these fees are income or a dividend, auditors and lawyers suggest that GPs can cite the nature of the GP and portfolio company relationship. “In the majority of these situations, the monitoring fees are being paid to the management company that generally has only a small indirect ownership interest, not the fund vehicle. Based upon that fact, it seems very difficult to conclude that the payment would represent a dividend,” says Nick Gruidl, of the tax advisory firm McGladrey. In the case of the GNC transaction, OTPP was acting not merely as an LP but most likely as a direct investor, with an ownership stake significant enough to warrant being structured as a dividend.

 

The second point to make with tax authorities are that these monitoring fees are often employed to offset, not waive, the management fees LPs owe the GP. If fees are earned from the LP or the portfolio company, the monies are still taxed as income for the GP. Several market participants suggest that recasting the fees as a dividend would mean the GP would actually be taxed less, erasing whatever additional revenue gained by making the fees no longer deductible.

 

However, if the fees were switched to a dividend as a standard practice, they’d be paid to the fund, not the GP, and the fund would simply pass along that dividend as a management fee to the GP, which would still be taxed as income. Certain foreign LPs might face some withholding tax on that dividend, but it wouldn’t be a substantial penalty. So the liability to both GP and LP remain largely unchanged, but the portfolio company would pay more.

 

To Polsky, that’s the crux of the issue: “The real problem is that the portfolio company isn’t paying the correct amount of tax to the federal government, resulting in millions or even billions of dollars of underpayments.” Which very well might be driving the IRS to contest the deductibility of these fees. However, GPs can argue that the use of monitoring fees to offset management fees might best serve the commercial interests of the various stakeholders in the process.

 

“Although the merits of this view can be debated, fund LPs generally take the position that private equity professionals should not receive compensation from portfolio companies for overlapping services that directly benefit the portfolio company in addition to management fee compensation from the fund,” says Daniel Meehan of the law firm Kirkland & Ellis.

 

As a result, fund LPs typically negotiate that some portion (50 percent, 80 percent or, increasingly, 100 percent) of the fees paid by a portfolio company to the fund management company for services that directly benefit the portfolio company and only indirectly benefit the fund to offset the management fee. And if those services can be explained, the IRS will frequently maintain the tax treatment of those fees.

 

“We have seen situations where the IRS has challenged the deductibility of monitoring fees paid by fund portfolio companies. Our experience has been that the fund management companies have been able to establish that significant management services have been provided to the portfolio company and the fees have been allowed as deductible expenses,” says Meehan.

 

Polsky admits this might be one solution. “They could go through the labor of connecting the monitoring fees to any services actually provided as in an arm’s length agreement, but that involves figuring out market rates, billing by the hour or the specific project, and allocating distinct responsibilities in the case of club deals. But all of that seems inconsistent with the business deal that is struck and also quite onerous to put into practice,” argues Polsky.

 

The lawyers pfm spoke with who’ve dealt with the IRS on this issue don’t find that level of detail being demanded. Instead, it is more about defining, in broad terms, what’s being contributed in exchange for that compensation (see boxout).

 

But how does the industry defend the termination clauses, where the service can end at any time, but the fees are, in a sense, forever? “With these long-term investments, it’s really a matter of compensating the managers for their services. And the fees may not be for quantity of service or counsel, but quality of it,” says Gruidl.

 

One lawyer suggested that an early exit frequently means that the fund manager has successfully repositioned the business sooner than anticipated. This does not make the fund manager’s services to the company less valuable in the aggregate. In some situations, it may indicate that the manager’s services were actually more effective, and thus more valuable, than expected.

 

The SEC also looks closely at these monitoring fees, mostly to ensure they shouldn’t be going to the LPs instead. If the fees are a dividend, this SEC scrutiny would likely cease. As a result, Meehan explored the possibility of restructuring monitoring fees as actual dividends on a special class of stock, but this quickly became complicated as it requires negotiations with all the stakeholders, such as the Company management or co-investors, who are performing no services to benefit the Company or were already being compensated for said services, in the form of salary, bonuses, etc.

“Each time we have explored using a dividend instead of monitoring fees, the idea has been rejected for reasons having nothing to do with tax – i.e., structuring the arrangement as a dividend on stock would not be agreed to by the other relevant stakeholders and, even if agreed to, would be far more difficult to document than a traditional monitoring fee arrangement,” says Meehan. 

 

There’s been no move away from the current language in monitoring fee agreements, but as the IRS continues to vet these arrangements, the lawyers and auditors we spoke with stressed that educating the tax authorities about the services rendered and rationale of the structure has worked well to maintain the status quo. But without formal guidance, the IRS could still change its mind and demand the fees be treated as a dividend after all.

 

 

When drawing up monitoring fees contracts, tax experts say GPs should focus on what services are unique to that particular portfolio company. A typical list might include:

 

Advice regarding the selection, retention and supervision of various advisors, consultants and relevant experts;

Advice regarding the strategic direction of the business;

And any other advice reasonably requested by the company in question.