Expenses are increasingly becoming a source of tension in the LP/GP relationship as managers shift more of the burden of paying for firm operations away from the management fee directly on to fund investors, according to a new ILPA survey.
This at a time when the SEC is considering stricter rules around GP fee and expense disclosure that some LPs believe are needed to level the playing field so fund investors of all sizes can get the financial information they need.
“Pricing and costs should be transparent to the partners in a partnership,” one public system LP told Buyouts. “If you went into business with an acquaintance and funded them to run a car wash and then they were calling and distributing your funds but were indignant at disclosing how much they are taking, at best you’d be a schmuck.”
The public system LP added: “And no respectable GP on earth would accept such a deal for their own business.”
Around 25 percent of LP respondents to Institutional Limited Partners Association’s Industry Intelligence Report, the key findings of which were made public today, said they are seeing administrative expenses like in-house legal, accounting and computer software shifted away from the management fee and charged to LPs as fund expenses.
As well, organizational expenses like deal sourcing costs, including travel, adviser and affiliate salaries and regulatory and compliance filings are “routinely” excluded from the management fee, the survey found. This finding mirrors ILPA’s same survey last year.
This shift is occurring as organizational expenses in private funds have exploded, ILPA’s survey found, increasing 123 percent since 2011. Fund expenses represents a murky category in private equity as compared to the better defined management fee and carried interest.
Part of the explanation for why this is happening could be tied to funds simply getting larger. And while management fees have remained relatively stable, between 1.5 percent and 2 percent, organizational expenses are rising. Usually, these expenses are capped, but LPs also are seeing more limitations on what those caps cover – often carving out side letter negotiation costs, for example, according to Chris Hayes, senior policy counsel for ILPA.
“Why should it cost more? Yes, the fund may be larger, and maybe there are marginally more LPs in the fund, but why should those organizational expenses grow so much along with the fund size?” Hayes said. “It doesn’t necessarily make sense, and indicates a lack of cost control for fund counsel.”
As well, in some cases, regulatory action forced GPs to move certain costs off the management fee and into the expense category as regulators sought more clarity about who pays for what.
“This resulted in increased point-by-point [breakdowns] on what fees are being charged, but also more direction about shifting those fees and costs to the funds,” a source told Buyouts.
The complexity and increase in fees, expenses, and fee offsets, at both the fund and portfolio company level, has created a challenge for LPs in validating that the costs match that of the LPA. Many LPs, particularly smaller institutions, are not able to negotiate to receive this basic transparency from their GPs, Hayes said.
Unfortunately, in today’s market many LPs don’t have much leverage to push back, especially with in-demand GPs.
“The management fee used to be used to keep the lights on … we’re seeing more of those expenses shifted outside the management fee, which [makes] the fee look like another income stream for the manager, rather than just being used to fund operations, as opposed to the manager relying on carried interest to drive their revenue and profit,” Hayes said.
“Obviously if the manager is relying on the management fee to make money, as opposed to sustain operations, then that’s not driving performance the way carried interest does,” Hayes said. “This has long-term concerns for alignment between GPs and LPs.”
The issue of rising expenses falls into the broader category of the cost of private equity that have long been a point of tension between LPs and GPs. The transparency of these financials such as fees but also valuations of portfolio companies, could soon be the subject of rulemaking by the SEC.
SEC Chairman Gary Gensler, in recent testimony, said the commission is exploring “reforms” for private funds around conflicts of interest and disclosure of fees. Compliance professionals said the commission’s main tool to implement reform is through rulemaking.
“Ultimately, every pension fund investing in these private funds would benefit if there were greater transparency and competition in the space,” Gensler said in testimony before the Senate Committee on Banking, Housing and Urban Affairs in September.
Total fund costs, including expenses and fees, can be tough for LPs to track and pin down to exact amounts. Many LPs simply look to make sure expenses are falling into an acceptable range, an insurance LP said.
“You don’t even try to figure out what the real number should be … you’re within the band, so you’re okay,” the insurance company LP said.
LPs in ILPA’s survey report improving financial reporting from GPs overall, but this doesn’t account for the need of many smaller institutions to have to negotiate for access to basic information.
The industry has not had widespread adoption of a standardized reporting methodology that would provide fund investors with a set of financials on a consistent basis. ILPA developed templates for private equity financial reporting, which have been adopted by some firms, but is not used broadly across the industry.
The SEC is exploring whether to simply force GPs as registered investment advisers under the Investment Advisers Act to adhere to strict rules for financial reporting. This would have the benefit of providing LPs of all sizes the same kind of financial information, without forcing smaller institutions to have to negotiate for consistent access to such financials.
“For good funds, LPs are saying, ‘I don’t want to make these guys too mad, because I want to get in.’ The LPs don’t have as much power as the SEC thinks they do, that’s why you need groups like SEC come in and say, ‘let’s level playing field for all LPs, and GPs and here’s info you need to provide.’ All you’re doing is leveling the playing field,” the insurance company LP said.
However, many industry sources, including LPs, have told Buyouts they don’t think a standard template form is the way to go. Rather, they’re hoping for a “principles-based” approach that identifies what fees and expenses need to be disclosed, and then allowing GPs the flexibility on how that gets reported to LPs.
The “principles-based” approach would provide better adaptability if and when rules change to accommodate new trends, sources said.