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Financeprivate equity

This Rhode Island private equity scandal is not a scandal

By
Dan Primack
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By
Dan Primack
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July 9, 2015, 1:28 PM ET
PROVIDENCE, RI - JUNE 15: Clouds hang over the river walk in Providence, Rhode Island, June 15, 2015. (Photo by Keith Bedford for The Boston Globe via Getty Images)
PROVIDENCE, RI - JUNE 15: Clouds hang over the river walk in Providence, Rhode Island, June 15, 2015. (Photo by Keith Bedford for The Boston Globe via Getty Images)Photograph by Keith Bedford — The Boston Globe/Getty Images

The Rhode Island Treasury is under some fire for paying management fees to private equity funds on capital that the private equity funds don’t actually control. It shouldn’t be.

I realize that, on the surface, the arrangement seems strange. But this isn’t akin to paying a stock broker before he makes a purchase on your behalf, and then letting him keep the fee even if you don’t invest.

When a public pension system — or any other institutional investor — decides to invest in a private equity fund, it agrees to commit a certain amount of capital over a finite period of time, to be called down at the fund’s discretion. As part of that contract, the investor also agrees to pay an annual management fee that is structured as a percentage of the capital commitments — usually between 1.5% and 2%, which arguably is excessive — with the percentage often ratcheted down once the fund’s initial investment period expires (even though it still maintains portfolio companies) or sometimes once a certain percentage of fund capital has been committed.

Management fees go into effect the moment a fund is closed, even if it hasn’t yet made investments. But this only makes practical sense, as the fund professionals have expenses to pay before doing deals. For example, how do you conduct due diligence on prospective out-of-town investments if you don’t have money to buy plane tickets? Or even more basic stuff like keeping the office lights on and phones answered? Particularly if it’s a new firm that doesn’t yet have any sort of balance sheet?

Moreover, private equity funds would have perverse incentives to do deals if they needed to invest in order to get paid. Rhode Island expects its money to be invested by private equity funds within a certain amount of time — usually five years — but doesn’t put undue timing pressure that could cause rash or unnatural decisions. The last thing you’d want to hear is that a private equity firm invested in order to satisfy the short-term financial needs of its staff, rather than the long-term financial well-being of its investors.

Finally, private equity firms could theoretically change their terms so as to require that investors actually write checks for their entire commitment up-front — so that they’d have technical control over the capital. But such a move would increase complexity for the funds and reduce flexibility for investors like Rhode Island, which use the lag time to invest the uncalled capital elsewhere (i.e., keep the money at work).

There are a lot of shenanigans when it comes to private equity fees, but this isn’t one of them.

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By Dan Primack
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