In March 2004, Bain Capital paid around $260 million to participate in the $2.6 billion buyout of Warner Music Group from Time Warner Inc. To date, the Boston-based firm has recouped its entire equity investment, made another $18.62 million via last month’s IPO and is currently sitting on another $375 million in Warner Music stock. So why aren’t all of Bain Capital’s limited partners smiling? Because investors in firms like Thomas H. Lee Partners and Providence Equity Partners-which also participated on the original Warner Music buyout-have done even better.
At issue is the way in which different leveraged buyout firms share transaction and monitoring fees with their limited partners. This is particularly important in the case of Warner Music, as investors received a $75 million transaction fee for the initial buyout, $10 million in management/monitoring fees and a stunning $73 million once the management/monitoring agreement was terminated by virtue of the IPO. Bain’s pro rata percentage of that amount, for example, was $32.85 million, while TH Lee generated $76.85 million.
A decade ago, it was common for buyout shops to take 100% of such payments. More recently, however, buyout firms have responded to LP pressure with a bit more generosity.
“I’m not sure that there is necessarily an industry standard, but buyout firms have moved more toward 60/40 [in the LPs’ favor] or 50/50 over the past five years or so,” says Erik Hirsch, chief investment officer for Hamilton Lane. “Usually, though, carried interest is applied to those fees, so a firm that gives 100% to its LPs may only be giving 80 percent.”
Examples of firms with a 100/0 split in their LPs’ favor include Warburg Pincus and Hellman & Friedman, while The Blackstone Group’s proposed $11 billion mega-fund features a 50/50 split, as did its $6.45 billion predecessor.
As for Warner Music shareholders, TH Lee reportedly features a 60/40 structure, while both Bain and Providence Equity Partners are at the 50/50 mark. On its face, therefore, it would seem that TH Lee limited partners actually get the shortest end of the stick on a pro rata basis, but appearances can be deceiving.
While both TH Lee and Providence generally pay out the aforementioned percentages (sometimes minus third-party consulting fees), Bain Capital has only done so in a handful of cases. Why? Because Bain doesn’t just keep the initial 1% and then apply 30% carried interest. It also charges for in-house consulting fees associated with each portfolio company. The strategy is part of the firm’s Bain & Co. consulting heritage, and almost always eats up any of the 50% of transaction and monitoring fees earmarked to LPs. In the case of Warner Music, for example, LPs aren’t expected to see any of the $16.42 million they theoretically have coming to them.
“Limited partners give Bain the money to do the deals, but then don’t share in all of the profits,” grouses one limited partner. “It’s completely unfair.”
Bain declined to comment on the record about its fee strategy, but sources close to the firm say that its lack of generosity is the natural outgrowth of having far more investment professionals than do most other LBO firms. According to last month’s issue of Private Equity Manager, Bain had 101 investment professionals on staff, as compared to just 26 at TH Lee and 35 at Providence Equity. As such, Bain would argue, it needs more cash to pay its employees, and has chosen this “keep the fees” path over increasing standard fund management fees. It also doesn’t charge “dead deal” fees. LPs, however, counter that this arrangement still winds up with the average Bain investor making a whopping $325,000 off of Warner Music fees, before counting fund management fees, carry or prospective profits off future liquidity events.
But this isn’t just about numbers. Bain believes that its aggregated investor masses help it add value that other LBO firms cannot. In the case of Warner Music, for example, Bain believes it was integral in the cost-cutting that helped Warner turn a $1.19 billion net loss from October 2003 to March 2004 into a $47 million net gain from October 2004 to March 2005. As evidence, it cites such things as the insertion of Bain managing director Michael Ward as interim CFO.
If Bain does, indeed, add more value than does TH Lee, for example, there is still the question of why those fees are passed on to the limited partner. Perhaps it’s unavoidable in a single-sponsored deal, but clearly not in the case of Warner Music. After all, if Bain is providing services that TH Lee and Providence would generally have outsourced, shouldn’t those firms be paying Bain a consulting fee?
Neither TH Lee nor Providence responded to requests for comment on the matter, and Bain-friendly sources say that Bain doesn’t charge consulting fees because the extra work is a trade-off for access to top-flight deals. The proof of this strategy’s success, they say, is that Bain’s most recent fund-raising drive was oversubscribed. If the situation were unfair, they argue, Bain would have been forced to change course long ago.