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The death of private equity’s fee hogs

Sep 05, 2013

FORTUNE -- For years, private equity firms have skimmed money from their portfolio companies, under the guise of "just trying to help." Now there is reason to believe this practice is coming to an end. Not because it's offensive, but because private equity firms are no longer reaping most of the rewards.

The fees I'm talking about here are "monitoring fees," in which an acquired company pays its private equity owners an annual sum for ongoing management and advisory services. You might have heard about these recently in the context of troubled casino company Caesar's Entertainment (czr), which each year pays nearly $30 million to its private equity owners -- Apollo Global Management (apo) and TPG Capital -- despite annual losses north of $1.4 billion (Caesar's could have killed the arrangement during last year's IPO, but it would have been forced to pay $195 million the privilege).

Private equity firms have historically justified these fees by arguing that they are in lieu of their portfolio companies having to pay millions to a third-party consultant, like Boston Consulting Group or McKinsey & Co. What this ignores, however, is that: (a) The monitoring fee arrangements are determined at the time of sale, not at the time of specific consulting need; (b) Private equity firms already are being paid to oversee their investments, in the form of annual management fees paid by their limited partners (which typically are between 1%-2% of committed capital). Imagine any other business where you get paid a salary, but don't show up to work until someone else also pays you to do the same job!

The real reason private equity firms have charged monitoring fees is that it can be incredibly lucrative. Take the Caesar's example. Between 2008 and 2010, it paid out an average of $28.36 million. And both Apollo and TPG only shared around two-thirds of monitoring fees with their limited partners -- as opposed to investment profits, which were shared 80/20. Not only could the firms get some downside risk protection, but they also got to disproportionately line their pockets. Sure the underlying asset got devalued a bit, but those losses would be born more by the limited partners (remember, 80/20). And the company signed off, didn't it? Or at least the people selling the company signed off (which really isn't quite the same thing).

But take a look at this chart from Pitchbook Data, which shows a sharp drop in monitoring fees over the past year:

This data comes from surveys, and shows that just 18% of Q2 buyout transactions included monitoring fees. So what happened? Is private equity buying stronger companies that aren't in need of "monitoring?"

Of course not. The big change has been that limited partners have waged a battle to change future fee-sharing arrangements, to their own benefit. And they've won. Even Apollo is offering 100% rebates on monitoring fees on its new fund, up not only from that 66% on past funds, but also from the 80% it originally offered this time around.

"We just don't commit to new funds that aren't 100% rebates," explains one pension fund manager. "It's becoming the norm."

Preqin published a study today showing that 63% of 2012/2013 vintage funds rebate 100% of such fees to LPs, compared to just 51% in 2010/2011. Another 15% of the 2012-2013 vintage rebate 80% of such fees:

Source: Preqin

So when private equity firms are promised a smaller cut (or no cut) of monitoring fees, they stop charging monitoring fees. The "need" has disappeared.

I spoke to several limited partners about this trend -- which they had all noticed -- and asked if they are upset, given that they now are the ones who would be reaping the monetary rewards. None were, believing that they ultimately will benefit from higher values upon exit (where the overall dollars are larger).

The only thorn in my argument is the above Pitchbook chart, which shows fairly consistent transaction fees (i.e., when PE firms charge companies fees in conjunction with the original acquisition). Such fees should be under similar pressure, since they too get caught up in the revised fee-sharing arrangements. All I can figure is that either (a) It's just a matter of time before these fall away, and (b) Transaction fees are a bit more justified, because they are substituting for investment bank work (particularly on sponsor-to-sponsor transactions).

In general, however, even partial progress is welcome progress. Private equity should be about profiting from increased value. Not about pocketing cash in exchange for just showing up.

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