Withum: (Sort of) breaking news

This article is sponsored by Withum.

The private equity industry seems to have dodged yet another bullet aimed at the carried interest deduction. As has been well reported, the language in the Biden administration’s Inflation Reduction Act of 2022 to extend the holding period on private equity investments from three to five years was stripped out of the bill at the insistence of Arizona Senator Kyrsten Sinema. Not willing to lose much-needed election year momentum if the Act was defeated, the Democratic leadership sacrificed the carried interest restriction in favor of a 1 percent excise tax on stock buybacks. 

If the failure of the latest attempt to rein in the carried interest deduction was not much of a surprise, it is worth noting that private equity remains squarely on the minds of legislators, and so the seemingly magical lifespan of carried interest continues, but it is just a matter of time before it comes under renewed attack.

Management fees

For the overall picture of private equity fund management, let’s look more closely at a few of the management fee findings that arise from the biennial Private Funds CFO Fees and Expenses Survey. Concerning fees, the survey asked: “What percentage of your transaction, monitoring or any type of investment-related fee received by an affiliated entity is offset against your management fee?” Analyzing those results, I note that fees such as monitoring, closing, financing and others are not being charged back by funds in a range from between 39 and 49 percent of the time. If the fees are charged in a range between 37 and 42 percent of the time, they receive a 100 percent offset.

When looking back at the results of the 2020 survey there does seem to be a shift in the 2022 results. Most funds in 2020 were not charging these fees, but if they did, most were doing 100 percent offsets.

There seems to me to be two reasons that these fees were not charged to funds in 2020. One was the concern over SEC enforcement actions against funds for overcharging on fees, and the second was a market shift back then from general partners calling all the shots to limited partners having the upper hand in the marketplace. Yet much can happen in two years’ time, and it would appear from this year’s survey results that the GPs seem to be in their regular position to dictate terms.

A shift from 2020 to 2022 is further revealed by the survey results regarding fee disclosure. When asked: “If your firm charges investment-related fees, do you disclose to investors?” The 2020 answer was 38 percent ‘yes’ on disclosure with that figure dropping in 2022 to just 30 percent. It is my belief that the higher level of disclosure in 2020 was a result of funds paying stricter attention to SEC oversight, and that it might be that the scrutiny is less of an issue in 2022. This will be a trend worth watching in subsequent
surveys.

Some additional observations from the 2022 results: the percentage of funds charging management fees from the fund’s first closing almost doubled in 2022, from 24 percent in 2020 to 47 percent in 2022. It seems plain that this was also due to the market being in favor of the GP. Further, all fees on 2022 successor funds showed little or no preference to the limited partners as compared with the 2020 survey.

There is a slight uptick in management fees (82 percent compared with 76 percent) being charged on invested capital for the post-investment period in the 2022 survey. Committed capital is another basis for management fees with the survey showing these fees decreasing in 2022 to 18 percent from 24 percent in 2020. Committed capital is used by the mid- and lower-mid-market funds to help them generate enough management fees to run their operations.

Finally, I notice that most management fee arrangements for funds that extend their life beyond the extension periods allowed are being negotiated at the time of the extension. I would have assumed this would have lessened over time, but it has increased since 2018. Why wait until the fund is past its life to negotiate these fees instead of doing it at the time of the fund launch? Apparently, it isn’t high on the priority list of either party.

For now, the tried-and-true private equity fee structure of two and 20 remains in force with little on the horizon to impede it. Indeed, the pendulum may have switched back from the last survey in 2020 when there was some pressure on the GPs to offset more of the funds’ charges.

However, the strong economic recovery, as evidenced by the remarkable level of dealflow recently, has empowered general partners to hold the line against charge backs. The numbers are staggering – according to Dealogic for the 18 months from January 2021 through mid-year 2022, dealflow was $1.7 trillion, by far the most in industry history. With this level of activity there is little incentive on the part of GPs to reduce charges in the immediate future.

But now there is a new and more troubling cloud on the horizon that may start to affect the strategy around management fees – the specters of inflation and recession. Rising inflation and the damage that it can cause to the fortunes of portfolio companies is very real and mitigation strategies are being instituted by every deal shop as we speak.

The private equity deals that are already underway will have to confront inflationary pressures on pricing, inventory and labor costs in traditional ways, such as price increases and layoffs. However, for deals in the pipeline it may be that we will see language in deal documents that reflect increases in fees because of higher expenses around the structure of new deals.

Limited partners may be on the lookout for ammunition to use to argue against higher fees. You can be sure that management is aware of this push back, in addition to the feeling that there may be the potential for lower levels of fund raising.  

Certainly, through the rest of this year and into 2023 fund management is looking straight into the eye of rapid inflationary pressure and, according to many economic forecasters, a recession in the third and fourth quarters of this year. Given these headwinds it appears likely the general partners will be looking to protect their margins by keeping fees at current levels. 

Of course, not all recessions are the same and if a recession appears to be severe or of a longer term than the short sharp one that is being talked about, there may indeed be significant pressure on general partners to eliminate certain charge backs, such as board of director fees, that could affect their rate of return. This is well within the realm of speculation but is worth considering. 

Indeed, there has been some suggestion by limited partners at mid-market funds (those in the $250 million-$750 million range) to replace the 2 percent fee that funds charge with a formula that caps all fees up to a set dollar amount with that cap being set by the fund’s seed limited partners. At the multi-billion-dollar fund levels there is also some activity around limited partner groups seeking to negotiate fee levels, but there is no new normal yet, and the very large funds do not appear to be in any hurry to adjust fees. 

The 2 percent management fee has been a standard almost since the inception of the private equity structure. Although there have been adjustments for offsets to certain fee revenue generated by the portfolio companies, based on this survey over the years, it doesn’t appear that there will be a change to the management fee anytime soon.