Value creation has become a favorite buzz term among private equity managers under ever-growing pressure to boost returns for investors. The days of simple multiple arbitrage are fading, and general partners now have to roll up their sleeves and drive growth in their portfolio companies, or at least hire people who can.
Operating partners – industry consultants often plucked from Fortune 500 companies and high-profile
multinationals – are now an essential part of the average fund manager’s tool box. Their importance is such that general partners now routinely use the pedigree of these professionals as a major selling point when on the fundraising trail. At the same time, the increasing use of operating partners has attracted the attention of the Securities and Exchange Commission.
Andrew Bowden, a director in the SEC’s office of compliance, inspections and examinations, highlighted the practice when he spoke at the PEI’s Private Fund Compliance Forum in 2014. He zeroed in on consultants who were effectively double-dipping – being paid on a retainer by the GP while at the same time sitting on the board of a portfolio company and collecting a director’s fee.
Broadly speaking, general partners should not let portfolio companies pay the operating partners. If they do, the private equity firm should offset remuneration from the management fee. In many instances, this hasn’t been the case, and the SEC is now taking action. “Many of these operating partners are paid directly by portfolio companies of the funds without sufficient disclosure to investors,” Bowden said at the forum. “This effectively creates an additional ‘back door’ fee that many investors do not expect, especially since operating partners often look and act just like other advisor employees.”
If operating partners are being paid by the fund or the portfolio company they advise, investors are unknowingly footing the bill for these resources in addition to paying a management fee to GPs.
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Meanwhile, in the eyes of limited partners, the operating partner may just look like any other part of the management. As Bowden said, they work exclusively for the GP, in the offices of the GP, they have the title of partner and they appear on the GP’s website and marketing materials as full members of the team.
Thomas Angell, a partner at consulting firm WithumSmith+Brown, says the pressure from the SEC on fees and expenses in the past two years has forced many GPs to be more conservative in their allocation of various expenses, including those related to operating partners.
“Nowadays, limited partners are placing extreme pressure on GPs to offset any types of fees charged at the portfolio company level that are perceived to benefit the general partner, in this case, director’s fees, which otherwise would have to have somehow been taken from the pockets of the general partners,” he says.
Yet, contrary to expectations, our survey shows that fewer firms are offsetting the operating partner cash director fee against the fund management fee when the partner is on retainer with the GP. About 38 percent of respondents who answered the questions said they offset director fees, down from nearly 49 percent two years ago.
On the other hand, Angell notes that more operating partners are being paid directly by the general partner, thus alleviating any issues related to portfolio companies paying compensation, fee offsets and ultimately SEC scrutiny.
“The operating partners who are typically marketed to the limited partners as being ‘the expertise of the GP’ would then appropriately be compensated by the GP, in more of an employer/employee type relationship,” adds Angell.
Indeed, this year’s survey shows that just 38 percent of respondents said that they still charged operating partner’s director fees to the portfolio company, indicating that direct compensation of operating partners by the GP is becoming the norm.
In future, Angell anticipates that private equity firms will continue to look at all the fees being paid and offset those fees if portfolio companies are paying operating partners a director’s fee. As investors continue to focus on the issue, it’s likely that limited partnership agreements will become more detailed regarding various fees and expenses incurred by the fund and its portfolio companies.
Despite the SEC’s focus on operating partners as a part of its push for more transparency on fees, the use of these industry specialists is likely to remain a core strategy for many private equity firms.
“GPs will continue to use operating partners in order to build the profitability of the portfolio companies,” Angell says. “The operating partners are brought in to help increase productivity, reduce costs from suppliers and build out the management team.”