While larger funds and fat staff rosters have pushed private equity firms closer to reaching that magical point of institutionalization, the lack of industry standards on issues like portfolio valuation and partnership terms leaves the business with at least one leg firmly grounded in the cottage-industry camp.
CFC Capital LLC, a boutique investment bank, recently released research showing that private equity firms also had no standard practice when it came to charging their portfolio companies advisory fees for investment banking services, such as arranging debt financing, acting as a merger and acquisition intermediary or acting as an initial public offering intermediary.
“While some portfolio companies pay advisory fees when a deal is consummated, not all sources of private equity provide advisory services to their portfolio companies, and those that provide such services do not uniformly charge advisory fees for them,” said
Art Rosenbloom, managing director of CFC Capital, in a prepared statement.
Rosenbloom, whose firm also offers specialized financial services, was acting as an expert witness in a case where a firm had charged a portfolio company a fee without agreeing to it in advance, claiming that fees were an industry-wide standard. Rosenbloom says that in fact there is no standard, but he did not hear of an instance where a fee was charged that was not previously agreed to in a written contract. Additionally, he says those agreements sometimes came at the time the original investment was made, and other times they were signed once the services became necessary-but always before they were performed.
Rosenbloom would not reveal any more details about the litigation, but he says his research, “should serve as a caution for private equity investors to secure written agreements with their portfolio companies before providing advisory services for them.” He also says, “To the extent that a venture capitalist is pressuring their portfolio companies [that this is an industry practice], this data is saying that it ain’t so.”
Chris Aidun, head of the VC practice at Weil, Gotshal & Manges LLP, says those types of fees are most common among majority investors such as buyout shops, and it’s often an agreement where a portfolio company will agree up front to engage the services of the banking practice associated with a private equity investor.
“The theory is that if you hire the investment banking arm of my company, there’s a different level of effort involved in it. If it’s the same as a third party relationship and it’s done at arm’s length rates, it’s not that reprehensible.”
“When you put it up front [before the original investment is made], then it’s an arm’s length relationship. Then, you’re not on both sides of the deal. Once you own the company and you want to charge them for it, then it’s a bit dicier. The question is where you draw the line of when it’s a corporate opportunity and when it’s an additional service.”
Or, as Rosenbloom states the question, “Under what circumstances would a private equity investor say, I’m going to perform these services simply as a means to improve my returns.'”
For some VCs, the whole issue of fees is a moot point. One New York venture capitalist says, “You’re not going to find many VCs bragging about it. If we’re going to sell a deal, in other words make an exit, we’re not going to take a cut.” He says that most VCs don’t have investment banking capabilities, but a few might get involved in making these kinds of introductions to generate some extra revenue.
Aidun says the Securities & Exchange Commission has been purposely vague on whether a broker/dealer license would be required for one-off advisory transactions such as these. The New York VC says that those VCs who have made a practice of this probably don’t have that license.
Rosenbloom based his data on 13 responses to a survey he mailed to 50 private equity firms listed as buyout and acquisition funds with $200 million to $800 million under management in an industry publication. He also read the prospectuses of 46 venture-backed initial public offerings and found only two companies that reported paying advisory fees to their investors.
Contact Charles Fellers