Who pays for outsourcing?

As managers decide which entity should pay for outsourced fund administration costs - the fund or the management company - they will encounter exceptions and gray areas. And LPs will certainly take a view.

The increasing pressure to reduce costs and appease LPs who are demanding greater transparency is leading more firms to outsource their fund operations. But as they do they should take care in designating whether certain costs are born by the partnership or the management company.

Fiduciary Compliance Associates principal Charles Lerner says the issue depends on what is meant by “outsourcing”. “You have to look at what the expenses were for,” he says. “If you are outsourcing auditing or bookkeeping, those are legitimate expenses of the fund. If it is going to be compliance, then it is really an adviser expense.”

Lerner says the first thing GPs need to do when allocating expenses is look at the offering memorandum. “That will spell out what expenses the adviser or the general partner pays for and what expenses the fund pays for,” he said. “But then you have to look and see, does this benefit the fund or does this benefit the adviser? Because the adviser is getting paid money to manage the fund, and his expenses – office space, computer, things like that – are really their expenses.”

The controller for a private equity firm with $8 billion under management says that while a fund pays its own internal people out of the management fee, in his view outsourcing fund administration is a fund expense. “I definitely see the argument for why it shouldn’t be a fund expense, but I think we specifically negotiated our language of what expenses could be negotiated by the fund, and so it was a business negotiation, a business deal, like anything else,” he said.

But the controller adds that generally believing that fund administration is something that can always be charged back to the fund is not always the right way to look at it, especially when “gray areas” come up. “A gray area would be when your document doesn’t specifically say that you can do that, that you can reimburse yourself,” he said. “If you have a gray area it is very difficult unless it had been required of your investors to make the case that it should be a fund expense. You could have two or three [internal] people for half the price of an administrator, so I think an administrator is an expensive charge which is why managers are so hesitant to charge that back sometimes.”

Traditional back office operations such as bookkeeping are areas that are clearly borne by the management company, but not when a firm is required to get a CPA to do its yearly audit of financial statements. “Those cost are without question viewed by the industry as being borne by the fund regardless of whether it is a CPA firm in the States or elsewhere,” said Jerry Chacon, a Fund Formation partner in the Business Law Department at Goodwin Procter.

Deal activity also involves outsourced service providers. With respect to sourcing and monitoring of deals, the data points are a bit more spread. In particular, Chacon says there are areas in which the cost of sourcing a particular deal clearly switches from the firm to the fund. “While some may debate whether the fund should bear the cost of having an MBA sitting in an office culling through various business plans, the sourcing costs associated with a particular deal are nearly always viewed as a fund expense from and after the point that the deal reaches the term sheet phase,” Chacon said.

However, Chacon also says that expenses like lawyer costs associated with specific deals are less important because they are often reimbursed by the portfolio company at the time of the investment.
Another sourcing cost that is often a fund expense is when a specialist is hired by the fund to handle an issue or provide expertise that the fund managers themselves don’t have.

For instance, if the fund managers are doing a deal in a field in a highly specialised space and need help from someone who is a specialist in that space, the cost of the report put together by such a specialist – even if it says not to make the investment – is often borne by the fund. “For the entire 10-plus years I’ve been doing this I’ve never had anybody push back on that so it seems to be tried and true,” Chacon says.

For his part, Chacon says that another recent “gray area” in the cost of portfolio monitoring is travel.
“The reason for that is that travel in the past has been very expensive, and so the investors seem to focus on those travel expenses that are being borne as an expense of the partnership. Items that have recently entered the debate have included the questions of when does the fund's expense start and end and are there any “collars” around the amount of the expense. “Investors have begun asking whether the reimbursement only covers a business-class ticket or whether it also covers a first-class ticket,” he said.

Negotiating expense allocation is often about the impression LPs get of the kind of organisation you are building. “In the past, that discussion has been around the question of, are you leveraging yourself or augmenting yourself?” Chacon says. “And if you refuse as an organization to hire a junior associate and just send this stuff out to third-party service providers, LPs often question that cost being pushed onto the fund.”

Chacon adds: “So if it is merely doing something that you could do yourself if you put in more hours or hired more people, then LPs believe that those expenses should be a back office entity expense. But if you hire someone to do something you can’t possibly do, LPs universally concede that those expenses should be a fund expense.”