Private equity’s new fee trick

Private equity’s new fee trick

By Dan Primack July 1, 2013: 11:44 AM ET

Private equity fund fees don’t always cover what they are supposed to cover.

FORTUNE — Almost all private equity funds charge their investors an annual management fee, which is used to cover such overhead as salaries, office space and administrative functions. It’s usually around 2% on uncalled capital, and begins to ratchet down as the fund ages.

We can quibble on whether 2% is an appropriate percentage — particularly when certain fund sizes become stratospheric — but it’s a fairly simple arrangement that both sides can easily understand before signing on the dotted line. Unfortunately, however, some private equity firms are beginning to violate the spirit of these agreements, by outsourcing certain activities and applying the charges on top of the baseline management fee.Most limited partnership agreements allow for additional fees to be charged if the fund is required to hire outside help, such as in the case of a serious legal issue. But I’m hearing more and more about how some general partners are hiring others for tasks that should reasonably be expected to fall under the management fee, in order to juice the bottom line. Including due diligence, which is the main thing that general partners are hired to do!

Here is how one veteran private equity exec explained it to me:

“Moving services out of the management company to outside service providers is the new new thing. If you fire your accounting group and hire an outsourcer, magically the costs move out of the management company and to the investors. Ditto, due diligence. Ditto secretarial. Ditto annual meetings. Ditto marketing.

Good for everybody (but investors).  (Very) large consulting and service fees for the service providers (and “friends of the firm”).  Particularly attractive tactic if you are a firm making most of your money off of fees rather than carry (because while it reduces ultimate return to investors, it is cash upfront to you).”

One place I’ve heard about some of this happening is inside of Credit Suisse’s (CS) Customized Fund Management Group, which uses an outside firm called Copal Partners for certain functions. Got to wonder if that little accounting trick is one reason that the bank has had troubles selling the group.

Again, to be clear, I’m not alleging any breaches of contract. It’s a violation of the spirit rather than of word. But that may change as limited partners begin to wake up to this shady practice, and begin to make future fund managers lay out exactly what management fees do and don’t cover.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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