Private Equity Portfolio Company fees. Ludovic Phalippou, Chris Rauch, Marc Umber

Transcription

1 Private Equity Portfolio Company fees Ludovic Phalippou, Chris Rauch, Marc Umber

2 A Private Equity Transaction BOARD OF DIRECTORS Seat & Control GENERAL PARTNER Appoint SERVICES AGREEMENT FEES & EXPENSES Control Repeated interaction future capital commitment EXECUTIVES PORTFOLIO COMPANY (PC) Hold Shares LBO FUND Pay standard fees Cash PENSION FUNDS, SOVEREIGN WEALTH FUNDS, ENDOWMENTS

3 Objective Document the content, existence and frequency of these Service Agreements Estimate the amount of transaction and monitoring fees charged Document potential time trends in the occurrence and extent of these fees Document conditional correlations in order to have a first empirical picture on these fees and assess conditions under which these contracts may or may not be optimal, and the main motivation for using them 3

4 What are Portfolio Company Fees? LBO Date and Players 2006 Bain, KKR, Merrill Lynch 2007 KKR, TPG, GS 1998 Fenway Partners TEV at LBO $33bn. $45bn. $871mn. Transaction Fees $146mn. $300mn. $5.1mn. Monitoring Fees $15mn. p.a. $35mn. P.a. 0.25% of Net Sales M&A Fees $2.1mn. - - Recap Fees $77.5mn. ($26mn. for IPO) $74.4mn. - Termination/Accelerated Monitoring Fees $181mn. - - Total Fees $470.7mn. $594.5mn. $15.9mn. Total Fees as % of TEV 1.4% 1.3% 1.8% Portfolio Company Fees, in return for certain services (e.g. monitoring) 4

5 Potentially interesting because Agency perspective: potential source for conflict of interest Peculiar features of contracts (e.g. no minimum service clause) Recently under scrutiny by SEC and institutional investors SEC investigation in 2015 into undisclosed fees, targeting portfolio company fees Dutch Pension fund refuses to continue investments into funds which don t adequately disclose all, and especially portfolio company-, fees; CalPERS committee meetings $39mn. settlement of Blackstone with SEC over undisclosed termination fees Widely used and economically relevant, but not well documented 5

6 Economic Relevance 6

7 Data Source SEC fillings by private equity-held companies in the US: IPO-exits: File S-1, 144A Companies with publicly traded debt: File 10k, S-4 Public to private transactions Filling companies have to disclose related party transactions Sample of 1,044 GP investments in 592 LBOs (25,000 pages of SEC documents) Transactions occurred between 1990 and 2012 Total deal value of $1.1 trillion (2014 dollars) Matched with fund- and GP characteristics (Preqin, proprietary PPM data) 7

8 Service Agreements (Overview) A Service Agreement between PC Executive and GP may be signed when the LBO is closed GP will provide the Company from time to time with management, advisory and consulting services Four types of cash-transfer items: 1) A one-time transaction fee 2) Annual monitoring fee 3) Post-LBO acquisition fees (in connection with recap, acquisitions, spin-offs, dividends etc.) 4) Refund of out-of-pocket expenses (lawyers, accountants; maybe GP internal costs; director fees) 8

9 Service Agreements (Timeline) LPs (Pension Funds, SWFs) commit capital to an LBO fund & sign the Limited Partnership Agreement (LPA) - contract on management fees, carried interest, and refund rule for transaction and monitoring fees Fees are being paid out LPs receive a fraction of the monitoring and transaction fees GP sponsors investment #1 in Portfolio Company A GP controls PC-A board Decides on: Executives appointments GP & CEO sign a Services Agreement which specify fees to be paid by CEO to GP 9

10 Contract Characteristics (1/2) PC fees and expenses are separate Transaction fees do not cover cost of executing transactions, monitoring fees do not cover director fees Consistently no minimum amount/quality of work is required to obtain PC fees in club deals, fees are split in proportion of equity ownership (not based on work done) Contract length is often longer than PC holding period by GPs Termination (usually) triggers the payment of a lump sum amount equal to the present value of the remaining monitoring fees (and sometimes of projected post acquisition fees) Not binding Can be cancelled/replaced at any time at no cost (if executive/board agrees) Some fiduciary duties are waved. E.g. executives cannot sue for unsatisfactory services 10

11 Contract Characteristics (2/2) Additional Features: Amount to be paid is entirely decided ex-post LPA and partly decided ex-post acquisition Management fees are ex-ante fees that should cover cost of acquisition and monitoring Part or all of the PC fees are rebated against management fees Board members of publicly traded companies are a priori restricted to enter such contracts Same person may sign contract for both parties (potentially falls under SEC self dealing rules) 11

12 In a Nutshell PC fees are partly ex-post discretionary compensation for GPs and partly a dividend to LPs (proportion depends on refund rule) Economic magnitude: $20 billion, equally distributed over past twenty years Represents about 6% of equity invested Average (maximum) refunded amount: 80% 12

13 Hypothesis I: Optimal Contracting Optimal contracting literature has not studied private equity context Four theoretical arguments to support view that MSAs solve incomplete dynamic contracting problem: 1) As LPs learn about GPs talent, maybe optimal to start with standard and low compensation Allows GPs to adjust it upward if and when GPs are successful (e.g. Robinson and Sensoy (2013)) 2) MSAs enable LPs to reduce GP profit volatility ex ante Saving on risk compensation, LPs pay less to GPs on average (e.g. Holstrom and Milgrom (1990)) 3) MSAs can counteract GPs bad incentives if Carry is out-of-the money or to invest in bad projects after LPs have committed capital Following Axelson, Strömberg, and Weisbach (2009) MSAs reset incentives. In financial distress of PC, it gives incentives for GPs to work hard 4) Portfolio Company Fees are subordinated to Debt Debt has to be repaid first in order to obtain fees (following Malenko and Malenko (2015)) Implications of these optimal views: PC fees should be company- and time-specific LPs should not react to the amount of portfolio company fees charged 13

14 Empirical Results I Fees are not related to GP past and current performance this result alone makes it difficult to reconcile MSAs with optimal contracts Fees are unrelated to company characteristics (including volatility of earnings) and do not vary over time with credit/business cycles State contingent effort hypothesis is not supported, neither is risk-argument Fees are not related to deal performance (including distress), meaning bad projects hypothesis is not supported either 14

15 Hypothesis II: Tunneling Cash is being siphoned out of Portfolio Companies into GP s hands Who loses out? Three potential victims 1) Tax authorities (following Polsky (2014)) GPs transfer cash out, call it a fee (in spite of lack of compensatory intent ) rather than a dividend because it is deductible from taxes GPs share the tax savings with LPs. 2) LP supervisors GP charge fees to portfolio companies to reduce LP management fees LPs report lower than actual expense ratios 3) LPs Cash is withdrawn from investments without consent Empirical implications as a function of victims: If tax or supervisor: LP should reward GP. If LP, LP penalizes GP, and PC fees depend on GP If tax: more PC fees when and where more corp. taxes are being paid 15

16 Empirical Results II Tax optimization is unlikely to be the prime motive Fees are not related to earnings before tax, are not higher in good times Almost all companies pay fees while only half pay corporate taxes The fraction rebated is often less than one minus marginal corporate tax rate Only partial support for tunneling LP supervisors Only monitoring fees are higher when there are more fund-of-funds among LPs LPs walked away from GPs that charged most fees when it became public information (post 2009) Relationship between future fundraising and current fees is significantly negative post-crisis No effect pre-crisis when fees were largely unknown LPs walking away post crisis, lower fundraising for high-chargers Strong GP fixed effect (persistence in fees R 2 doubles when controlling for past fee policy of GP) GPs refunding the most charge the least 16

17 High Chargers vs. Low Chargers High Chargers Low Chargers 17

18 Is this Yesterday s Question? Not a dying thing Blackstone earned $327mn. in 2014, $253mn. in 2013, and $255mn. in 2012 of Management and Advisory Fees This fees were equally high 20 years ago Even if that was to stop, would be good to know what happened and why it could stay for so long At present, move to 100% refund to LPs, but companies would still be charged It is a sizeable transfer of capital. Worth knowing about it. 100% is not 100% refund: it is offset only up to the amount of management fees and these may be lower than PC fees, especially late in the fund s life 18

19 Take Away Transaction and monitoring fees are controversial Seem high, and GP is supposedly already paid for transacting and monitoring Especially problematic if deal/gp does badly because no longer repeated game Seem to lack compensatory intent Although there is probably a tax consequence, evidence we assemble is not consistent with tax being the main motivation But difficult to rationalize, too If it is because of optimal compensation, then how to explain 100% refund? LPs seem to penalize GPs who charge more of these fees, GPs with lower returns seem to charge more but no obvious large-scale tunneling 19