Back in March, as the profound social and economic impact of the global pandemic was becoming terrifyingly clear, private funds managers were bracing for the unprecedented worst. Minds were focused, foremost, on shoring up portfolio companies in any way possible, managing the safety of firm and portfolio company employees, and communicating feverishly with LPs.
But it also caused CFOs to take a deep look at their budgets and operating capital at the firm level, and at fund-level working capital.
“This is one of the first times that people have had to seriously look at their GP budgets,” said one New York-based private equity CFO at the time, noting many had done so in the immediate aftermath of the 2008 crisis. Yet that was more than a decade ago, when many of the funds operating today were still gleams in the eyes of their future founders.
“There are pockets with our service providers where we can start to potentially rethink the economic relationship”
Global mid-market CFO
The scenario for many funds has since become less chaotic, at least compared with initial fears – and at least for now, as uncertain as the future of the global economy remains. But it has no doubt caused firms to reassess costs. The Financial Times reported in June that KKR had become possibly the first private equity firm to ask its financial and legal advisors to “share the pain” by reducing fees. This spread consternation among service providers that the private equity giant, which declined to comment on the report, might start a trend.
Covid-19: A fee desert, for some
The pandemic has certainly had an impact on firms’ economics. Transaction fee revenues, both for acquisitions and exits, have plummeted for many firms, with market dislocation causing dealflow to evaporate. For funds that rely heavily on such fees, particularly emerging managers, that has meant a significant loss of income. Those fees can also make up for decreasing revenues from stepped-down management fees in the later life of a fund, as exits tend to increase at around the same time.
“There’s more stress for us, because we had budgeted in earning transaction fees,” says the NY CFO.
Some firms have also deferred advisory and monitoring fees to relieve stress at portfolio companies, and in some cases those fees may not materialize at all (see panel, ‘Monitoring fee Uncertainty’).
The fees can be significant for firms that do rely on them. One CFO at a small mid-market firm that has deferred advisory fees estimates its normal intake of advisory fees at more than $750,000 a quarter. Even with a high offset rate against LP management fees, other accounting idiosyncrasies result in those fees adding up to meaningful income.
Monitoring fee uncertainty
A struggling portfolio company that refuses to pay fees can mean everyone loses, writes Carmela Mendoza.
For some firms that rely on monitoring or advisory fees, a struggling portfolio company refusing to pay up can be a serious threat to firm economics.
Portfolio companies pay their private equity owners annual sums for ongoing management and advisory services after acquisition, known as monitoring fees. These arrangements are often structured as five-to -10-year deals or until firms cease to hold a specified level of equity ownership. Some firms require their portfolio companies to prepay monitoring fees at the time of acquisition for all or for a significant portion of the term of the management agreement.
A struggling portfolio company refusing to pay monitoring fees can present a severe challenge for firms that rely on them. Such a refusal would represent a breach of contract, but a hard one to enforce, says Eamon Devlin, partner at MJ Hudson: “A GP is unlikely to sue a portfolio company for unpaid monitoring fees as the GP is the equity owner, so putting the creditor into bankruptcy is not a valid option.”
The issue of non-payment of monitoring fees is not currently widespread. However, Devlin adds that for some industries hit hard by the crisis, including travel, leisure and hospitality, that may well change. GPs may also face problems with such portfolios when government aid packages, such as ‘furlough’ schemes, get turned off, thereby placing further pressure on the firms’ economics.
However, most PE managers do not rely heavily on advisory fees. Managers have increasingly offset deal-related and advisory fees against LP management fees: 92 percent of funds surveyed by MJ Hudson said they offer a 100 percent offset provision.
Management fees – the steadiest form of income for many funds – also have an uncertain future in a market where some managers may well face difficulty raising new vehicles. After the investment period, management fees step down from a median of 1.75 percent, usually on committed capital, to 1.50 percent, usually on invested capital, according to a study from consultancy Callan.
“These pain points are causing some GPs to step back and ask, ‘Is our deal funnel broken? Do we need to rethink how and where we’re sourcing deals?”
“You could be stepped down by millions of dollars,” the NY CFO says. Should the firm not be raising its next fund and rely heavily on management fees, the CFO adds that this would be a “cliff edge.”
There are steps managers can take to alleviate the stress of lowered or no management fees, says Elaine Chim, head of private equity and real estate at financial services provider Apex Group.
“For those managers nearing the end of their investment period with capital to deploy, the obvious one is to amend the step-down date due to the disruption and delays caused by covid-19 earlier in the year,” she says.
“For funds nearing the end of their term, there could be amendments to extend management fee charges to keep the lights on longer in order to allow for more time to achieve the target or to give the manager more flexibility to exit at a more optimal time.”
There has also been a reported increase in management company credit lines – separate from GP lines, which fund GPs’ capital commitments – to ease the pain of deferred fees, carry clawbacks and the like. Such lines are extended against a sponsor’s right to receive management fees and can be used for a variety of purposes, including to fund compensation.
These pandemic-induced pressures will affect every firm differently, of course. But, for some, the first thing the crisis has thrown into uncertainty is compensation.
Without deep-pocketed partners stumping up in the meantime, the CFO of the smaller mid-market firm says the current dynamic would hit bonuses for the year. For the NY CFO, bonuses are a “very substantial piece of our expense base” that in normal times are part of expected comp, but which represent a large lever that can be pulled in times of stress.
“Some GPs will be very stressed, some will be not impacted at all, and it has nothing to do with how the investments perform. It’s how they’re organized”
New York-based CFO
The NY CFO says that delaying or cutting bonuses or taking other measures to prop up the management company – another CFO even suggested salary suspensions for senior partners – could be complicated by having a third-party investor, such as a GP stakes fund, in the management company: you do not necessarily want to fund someone else’s equity.
The NY CFO notes that compensation can also be traded for a fund stake or carry. This is a potentially easy and useful tool in times of stress, though it becomes less attractive if the fund faces little or no carry or longer-term performance problems.
There are also longer-term pressures on the economics of private equity. It is well known that LPs have increasingly put pressure on their managers for greater fee transparency, especially amid broadly declining returns in step with increasing asset prices.
Some think that, over time, fees will be reduced regardless of the pandemic. During an interview at the Private Equity International CFOs & COOs Forum in New York in January, Thoma Bravo co-founder Carl Thoma predicted private equity’s traditional “two-and-20” model would not last the decade. “Our fees will definitely come down… in the next 10 years,” he said. “We will go into a recession and we’re paying super-high prices.”
He projected that management fees were likely to migrate to around 1.5 percent, and carry to 15 percent.
Covid chomps on comp
Antoine Dréan, founder and chairman of Triago, predicts that a consequence of the collapse in asset values will be the wipeout of profit sharing for many managers. By Carmela Mendoza.
Those with heavy exposure to the hospitality, travel and energy sectors are particularly likely to see permanent impairment, writes Antoine Dréan, founder and chairman of Triago, in Ten Predictions for How COVID-19 Will Transform Private Equity.
He adds that even at firms where hopes of getting back into carry are reasonable, it may take years of hard work to return to such levels. This could result in junior staff jumping ship and founding their own firms.
A survey in May by recruitment firm PER of 300 PE professionals revealed that more than 60 percent expected carry to decrease in value. Of these, 85 percent also expected payments to be delayed.
Although 83 percent of respondents expected no change in base salaries, 52 percent expected bonuses to decrease, and 10 percent of those estimated a reduction of more than 50 percent.
Nigel Mills, a director at executive search firm MM&K, notes from conversations with industry participants that an important stated reason for the scaling back of bonuses is the recognition by firms that they are going to need to recruit more staff – particularly at the associate and analyst levels – to help deal with the additional workload the pandemic is going to bring.
He sees this additional workload as being driven by two factors: first, GPs need to monitor more closely and provide extra support to their existing portfolio companies; second, GPs need to research, identify, carry out due diligence on and execute new deal opportunities that are expected to come up later in the year at potentially attractive prices.
Significant reductions to management fees could threaten business models. The CFO of the global mid-market firms says that when LPs began pushing for management fee offsets to advisory fees charged to portfolio companies, it caused a “seismic shift” in the firm’s economics and operations. The firm had to find ways to move more expenses to the funds and shifted its portfolio company operating resources to the companies themselves. Many firms used to split portfolio company fees with their LPs; now, LPs effectively take the lion’s share or all of those fees via offsets.
Private funds budgets: Awkward beasts
Other key trends affecting operating capital existed long before covid-19. Some have bubbled beneath the surface of the main event of the sector’s steady growth, while others have slowly and perhaps clumsily evolved out of changing necessities. Bryce Klempner, partner at McKinsey, says: “The PE industry has been sufficiently lucrative and the pace of growth sufficiently fast that as new operational needs have come up, the default response for most GPs has been simply to throw new people at the issue, rather than stepping back and asking, ‘How do we efficiently structure a larger business?’”
“Our fees will definitely come down … in the next 10 years. We will go into a recession and we’re paying super-high prices”
At many funds, that has led to an awkward, unwieldy budget beast. Speed of processes; quickness of response time to LP requests; the necessity, often, of immediate response to problems as they arise: all have led to what Klempner describes as “creeping, incremental customization.”
“One result of ad hoc evolution is that GPs’ internal tools and systems tend to be customized, as most believe their needs are completely unique,” he says. In a sense, they often are. GPs are well known for being structured idiosyncratically. “Some GPs will be very stressed, some will be not impacted at all, and it has nothing to do with how the investments perform,” says the New York-based CFO. “It’s how they’re organized.”
LP fees: The investors strike
Should the fundraising environment cloud over, LPs could take the upper hand in fee negotiations – with consequences for managers’ business models, writes Carmela Mendoza.
An analysis by investment consultancy Callan of fees and terms for 90 private equity partnerships found a relatively high level of uniformity, thereby suggesting that GPs have significant bargaining power.
However, Ashley DeLuce, a vice-president in Callan’s private equity consulting group, says this could change as the balance of power shifts to LPs amid the market disruption.
Such a shift will take time to manifest itself and will depend on whether less established managers hit significant hurdles in raising funds. It would also be unlikely to occur for large, reputable GPs, which stand to benefit from investors becoming more selective about their managers.
“Going into the pandemic, funds that were already raising capital weren’t really affected [by difficult fundraising conditions], as LPs were already committed or finishing up diligence,” says DeLuce. “With the onset of summer, we did start to see some fundraises delayed or their timelines extended, although that is not the case uniformly. Some have even gotten pushed out to 2021.”
Should that shift in power occur, DeLuce says, it could take the form of management fee discounts, or greater transparency on fees during fundraising.
Lower management fees might be negotiated by LPs in exchange for a fund term extension, says Elaine Chim, head of private equity and real estate at financial services provider Apex Group. Over the coming months, she says, specific side letter conditions could also include deferring the call for management fees.
Wait and see…
The head of alternatives at a European pension says that, at least for now, the crisis has actually given the best managers an even greater advantage in fee negotiations, as investor capital flies to quality.
“While it’s been easier for us to ask for better terms on the debt and real assets side because those markets are more nascent, private equity is incredibly tough,” the senior executive says. “You’re actually lucky to just keep the terms you have in your previous fund. Most of the good GPs have worsened their terms instead of made them better, and it’s kind of take it or leave it.”
Despite the disruption, LPs are still supportive of private equity and allocations remain high, which bodes well for GPs’ fee advantage. Capital raised by private equity funds in the first half of 2020 reached $241 billion, a slight increase on the previous half-year figure of $234 billion, according to data from sister title Private Equity International.
However, Klempner says there are shared pain points for most private funds. In private equity, for example, the model originally centered intensely on one or a handful of talented investors; but the institutionalization of the industry has brought along a bigger middle and back office, and more costly, specialized professionals across operations. LP demands for transparency have added significant costs, while returns have broadly declined amid higher asset prices.
Anecdotally, there has been a significant increase in recent years in ‘broken’ or ‘dead’ deal fees being charged to fund managers. One CFO at a global mid-market firm called for means and metrics to meaningfully analyze the impact of these fees on performance. Many managers pay such fees out of firm budgets, allocating them to funds later when it is clear which fees were paid on deals that did not pan out. The NY CFO says they can represent significant, if temporary, outlays for management companies, and in some cases they are never fully allocated to funds.
“For funds nearing the end of their term, there could be amendments to extend management fee charges to keep the lights on longer”
That increase in fees may have been temporarily reversed for many. But they will be back, and those other ‘pain points’ Klempner mentioned aren’t going away either.
Treating the pain
“These pain points are causing some GPs to step back and ask, ‘Is our deal funnel broken? Do we need to rethink how and where we’re sourcing deals?’” says Klempner. In some cases, that can lead to increased pressure, and possibly cost, internally, by raising the bar for teams to engage with external advisors, and forcing them to do more research and footwork on their own.
Some CFOs are taking, or thinking about taking, remedial action to deal with the increased costs.
The CFO of the global mid-market firm says: “There are pockets with our service providers where we can start to potentially rethink the economic relationship.”
The CFO adds that some providers unilaterally offered to lower rates during the 2008 crisis, though none have yet come forward this time around. Over the next few months, the firm expects to have conversations with providers whose contracts are up for renewal.
Where’s the line on tech expenses?
Use of technology has surged since the pandemic struck, but who pays for what tech investments? Connor Hussey reports.
Lockdowns across the globe caused demand for technological solutions from private funds to soar, say experts. With work-from-home initiatives suddenly thrust upon them, fund managers immediately needed ways to facilitate remote working while being flooded with investor requests for near-continuous data and updates on their interests.
“There’s been a massive upsurge in interest in terms of having both the fund manager and the LP being able to do analysis on the underlying portfolio and seeing how it’s being affected,” says Hugh Stacey, executive director of investor solutions at IQEQ.
Portfolio management or customer relationship management software – such as SalesForce, BlackRock’s eFront or IHS Market’s iLEVEL – have helped GPs to answer that demand.
Cybersecurity costs have also soared for some firms.
“Maintaining cutting edge cybersecurity – that’s going to require constant reinvestment every year,” says Robert Hull, global chief financial officer and chief operating officer at L Catterton. “It’s so dynamic that what made sense last year is actually irrelevant this year.”
The cost of working remotely
Remote working conditions have only placed more pressure on firm’s cybersecurity tools and protocols – and required additional investment.
“Maybe it’s because we’re only [focusing] on technology solutions all day, but we’ve probably tripled our spending [on cybersecurity],” Hull says.
Increased tech spending is not a new trend, nor is it one that is likely to abate in the foreseeable future. In EY’s 2020 Global Private Equity survey, 75 percent of private equity CFO respondents expected their finance teams to spend more time on technology and investment portfolio analytics over the next two years.
But who benefits from, and pays for, technological investments is still a matter of debate between GPs and LPs.
“You can expense some of the expenses to your funds,” says Hull. “But that’s a fund-by-fund exercise and discussion to be done with great care.”
Another CFO, at a Midwest buyout firm, says increased requests from LPs during the onset of the pandemic forced it to update its general ledger and customer relationship management systems in order to access and provide information faster. LPs are helping to fund these investments.
“For us, CRM is a fund expense and a portion of the general ledger expense is a fund expense – the portion related to the actual fund accounting,” the CFO says. “Anything that we’re doing on the corporate accounting side or management company side, that’s our expense.”
However, Hull says tech investments charged to the fund come with certain investor expectations. “If I have a fund and I expense something to it appropriately, [LPs] see that as a capital investment and they expect to get paid back and to get a percentage on top of it,” he says. “So there’s a cost of putting expenses against the funds.”
A fourth CFO says their firm is trying to add an administrative fee on top of its management fee for its next fund, which is still being raised. This is to account for the cost of some of its staffing functions that would otherwise be outsourced, which the CFO says would be more expensive.
The CFO adds that the fee was for expenses already allowed under the limited partnership agreement, but that the firm had previously not charged it to the fund.
A fifth CFO had heard rumors from peers that some firms were looking to charge even their finance teams or general counsel to funds, in the latter case by using industry rate cards to decide on fee amounts.
Of course, more of these cost pressures can be offset with outsourced services, which are often charged to the funds. Klempner says this is where “creeping customization” gets in the way.
“There’s a tendency in the middle and back office to say, ‘We can’t use an off-the-shelf product for this or that process, because everything is so unique to us,’” he says.
“But GPs have started to realize that if they break a complex, even unique process apart into its constituent chunks, some of these pieces may have already been commoditized and needn’t be run internally in a wholly bespoke manner.”
The CFO of the global mid-market firm agrees: “One of the things we are trying to do is figure out the best way to outsource the outsourcer.”
This means breaking roles down further and finding responsibilities that can be discharged externally to potentially reduce costs by a significant amount.
When it comes to one of the biggest cost pressures – the ever-growing requirements of investor relations to deal with LP requests, which have also surged during the pandemic – a sea change in approach could be in the works too.
“For many PE firms, there’s never been any differentiation in service levels by client – no gold, silver, or platinum distinctions – rather, everybody’s platinum,” says the CFO of the global mid-market firm. “Today you’re seeing firms start to think about whether there should be different tiers of service in IR in addition to growing differences in net fees, access, and transparency.”
Covid ups reliance on, and cost of, outsourcing
Managers have been leaning on their outsourced service providers because of the increased pressure on operations. This could spell a change in back-office expenditure once the dust settles, writes Connor Hussey.
“Our interaction with compliance consultants and IT consultants has significantly increased during this time,” says Dimitri Korvyakov, chief financial officer at Sandton Capital. “Naturally, their involvement has increased and the fees have increased.”
Before the pandemic began wreaking havoc on PE operations, Private Funds CFO documented the steady rise in the outsourcing of firms’ back-office capabilities.
“Originally, outsourcing was only considered clerical work, which is really where outsourcing started – it was a cost play,” says Brian Black, director of business services and outsourcing at BDO. “And while that still is a component, things have shifted over time to look at quality as opposed to just [a] cost play.”
Changes to the way firms are operating as a result of covid are accelerating this trend. Part of this is driven by an increased acceptance of remote working.
“[Working remotely] is something [firms] didn’t think they could do previously, and [covid-19] sort of thrust companies into that environment,” says Black. “Now you have a situation where the barrier to entry for outsourcing – where it was a challenge before because you didn’t want someone working remotely – now you’ve proven it can work.”
Another significant driver is pressure from investors and regulators.
“LPs play a significant role. Investors increasingly want to work with GPs that are able to focus all of their time on investment decisions and leave the back-office operations to a team of experts,” says James Duffield, head of business development at Aztec Group. “This approach minimizes direct operational costs and the administrator can provide considerable economies of scale across functions, such as accounting, reporting, compliance and AML [anti-money laundering].”