The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “DFA”) was signed into law in July 2010 and the DFA required that firms with $150 million or more in assets register with the SEC as investment advisers. A number of private equity firms became subject to SEC oversight. The SEC has an Office of Compliance Inspections and Examinations (“OCIE”) and the Director of OCIE is Drew Bowden. Mr. Bowden gave a speech in May of this year in which he reported that OCIE has 900 examiners who had, at that time, examined more than 150 newly registered private equity advisers. Among the many topics discussed in Mr. Bowden’s presentation (entitled “Spreading Sunshine in Private Equity”), expense-shifting fees and inadequate disclosure of fees were two that he highlighted. Monitoring fees were identified as a hidden fee.
As has been well publicized, private equity firms typically charge their investors a management fee and a percentage of profits. A management fee of 2% and a 20% profits interest is typical (and is the so-called “2 and 20” you hear about when people discuss the cost of investing with a private equity firm or a hedge fund).
For years, many private equity firms have charged their portfolio companies a monitoring fee (for board and other advisory services) that is usually a fixed amount per year (but is sometimes calculated as a percentage of revenues or profits). The monitoring fees are pursuant to a written agreement frequently called a Management Services Agreement (“MSA”). Although the typical MSA is in effect for a 10-year period (some have terms of 20 years or more), virtually all had a provision requiring accelerated payment of the balance of the monitoring fees for the full term of the MSA if the portfolio company were sold prior to the end of the stated term of the MSA. Since the typical private equity holding period is around 5 years, this meant that private equity firms were being paid monitoring fees for monitoring services that they would never have to provide. But that’s not all.
Some private equity firms (and their crafty lawyers) started providing in the MSA that each year the MSA would renew and extend for 10 years. That meant that there were always at least 9 more years of monitoring fees that would be payable to the private equity firms upon a sale of the portfolio company.
Mr. Bowden noted that the SEC believes that private equity firms were not adequately disclosing the complete story regarding the monitoring fees (and other fees) to the investors in the private equity firms’ buyout funds. Keep in mind that the charging of monitoring fees has been a very common practice in the private equity world. Mr. Bowden noted that, as a result of the SEC’s examination of private equity firms, the SEC believed that more than one half were allocating expenses and collecting fees inappropriately. The SEC believed that certain of the fees and expenses being charged by private equity firms should have been covered by the management fee. A number of private equity investors have made the same argument for many years.
So how did the big private equity firms respond? Blackstone indicated it would share accelerated monitoring fees with its investors or reduce other fees by an equal amount. TPG has also announced that it will return its share of accelerated monitoring fees by cutting management fees in its next buyout fund. Apollo has indicated it will share 100% of all fees in its buyout fund.
To give two examples of the dollars involved, The Wall Street Journal reported that the accelerated monitoring fee was $181 million in the HCA Holdings sale in 2011 and $88 million in the pending Biomet sale.
Many people, the SEC included, believe that private equity firms did not adequately disclose the potential for accelerated monitoring fees, the monitoring fees reflect a conflict of interest since no one was looking out for investors when the MSAs were negotiated (after all, the private equity firms were negotiating with themselves) and private equity firms simply got too greedy by using MSAs with the automatic 10-year extensions or overly long terms. Private equity firms would quickly counter that investors in the buyout funds were highly sophisticated and experienced investors with top-notch legal counsel and that such investors were well aware of the long-standing practices as to monitoring fees (and other fees). Finally, private equity firms would point out that, even with the accelerated monitoring fees, private equity firms have provided very satisfactory returns to their investors.
The bottom line is that private equity firms needed to more thoroughly explain their fee practices and, more importantly, private equity firms and their counsel need to increase and enhance all aspects of their disclosure to investors, but particularly as to fees and expenses. The old days of general discussions of fees will give way to clearer disclosure of fees and fee-related matters. The very successful private equity industry will adapt to the new rules of the game.