Paul Capital’s real failure is in the fees

March 21, 2014, 7:45 PM UTC
Paul Capital is now a member of the Fee Hog Hall of Shame

FORTUNE — Almost all private equity firms charge their investors pre-negotiated annual management fees, ostensibly for the purpose of covering overhead costs like employee salaries, office leases and Friday afternoon pizza parties. But what happens if a firm fires most of its staff, closes most of its offices and tells the Domino’s guy to get lost?

That is the situation at Paul Capital, the private equity secondaries firm that recently chose to wind down operations after failing to find a buyer. And it is shameful.

For the uninitiated: Paul Capital was flying high prior to the financial crisis. It had raised $1.65 billion for its ninth private equity secondaries fund, had a burgeoning healthcare royalties practice and well over a $1 billion of assets under management in its funds-of-funds group. But it invested most of Fund IX just before the financial crisis, when secondary prices were unreasonably high. Even worse, it had largely avoided many of the mega-fund commitments that, in retrospect, came through the crisis in decent shape (instead focusing on non-auctioned positions, including in emerging markets).

In April 2011, the fund-of-funds team spun out into an independent entity called Top Tier Capital Partners. Last spring, the healthcare royalty team bolted to Visium Asset Management. At the time, Paul was still in market with its tenth secondaries fund, but it wasn’t getting anywhere close to its $2 billion target (reports suggest it only secured around $500 million). So it began looking for a buyer, ultimately entering into protracted negotiations with Hamilton Lane Advisors. The real problem with Hamilton’s successive offers – which may have actually gotten smaller rather than larger – was that they were basically just for Paul Capital’s assets rather than for its organization. In other words, the Paul employees would be out of a job.

So Paul Capital management made a calculated decision: They could make more money from winding down the firm and continuing to collect management fees than they could from a sale.

Within the past week, Paul Capital sent limited partners a terse letter that I’m told included five salient pieces of information:

  1. 1. The firm would lay off all staff except for a small number of back-office professionals in San Francisco, including CFO Phil Jensen. For context, the firm had 65 total employees, including 31 investment staff, as of earlier this year;
  2. 2. Most portfolio managers are likely to seek out other employment;
  3. 3. Five of the firm’s six offices would be closed;
  4. 4. It would not all down the $300 million of so of Fund X commitments that had not yet been called, although a source familiar with the situation puts the real figure at closer to $115 million (as the remainder was contingent on Paul raising more capital).
  5. 5. Management fees would remain unchanged.

It’s the last one that is so incredibly galling, and many of the LPs I spoke with are outraged over it.

“I appreciate that we’re going to get ongoing reporting and the investments will be managed out, but this is a secondaries fund,” one LP said to me. “Once you’ve made the investments, there isn’t really much to do except sit and wait – unless you’re looking to sell because of changes in the market, which you won’t know because the investment staff is gone. Why should we be paying hundreds of thousands, or millions, of dollars per year for that?”

I tried to ask Paul Capital that very question, but every employee I spoke with (past and quasi-present) directed me to CFO Phil Jensen – who did not return my messages or emails. Also worth noting that I reached out to each of Paul’s senior partners, but have gotten a similar brand of bupkus.

A big problem here is that LPs don’t have much recourse, save for refusing to permit fee extensions if such requests are ever made. Perhaps they could band up and force Paul Capital to sell the assets, but that would require a level of coordination that LPs are not traditionally known to exhibit.

So the checks will keep being cashed by a group of people who, for the most part, has explicitly checked out. It’s things like this that give private equity a bad name.

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