Fees and Expenses 2014 A benchmarking survey · Fees and Expenses 2014 A benchmarking survey ......

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PEF SERVICES • PEPPER HAMILTON

Fees and Expenses 2014

A benchmarking

survey

OVERVIEWWhat’s really going on with fees? p.18

PART I: REGULATORY EXAM EXPENSES

Unwelcome visitors p.20

COMMENTLessons from Igor p.23

PART II: DEAL AND MONITORING FEESFee watchers p.24

PEF SERVICESSurvey says: Size matters not? p.26

PART III: THE ANNUAL MEETINGLimited expenses-paid vacation! p.29

PART IV: DEAL COSTSBlurred lines p.32

PEPPER HAMILTIONThe new reality p.36

PART V: OPERATING PARTNERSWhen value-add goes wrong p.39

If you were at the PEI Private Fund Compliance Forum in New York earlier this May, you’ll probably

recall the collective intake of breath after Drew Bowden delivered his now-notorious speech “Spreading Sunshine in Private Equity”.

Bowden disappeared pretty quickly after his speech, leaving in his wake a crowd of compliance officers exchanging raised eyebrows and

nervous stares. The revelation that the SEC had found “violations of law or material weaknesses in controls” at half of the 150 funds recently examined by Bowden’s team was quite an eye-opener.

We’ve reported since that the SEC’s call for more transparency is already having an effect on how GPs communicate with investors around fund expenses.

But it’s still not clear exactly what the SEC’s position is. Which expense allocations are considered safe, and which are considered unjustifiable in any circumstances? In light of Bowden’s warning, are you now wondering whether your firm should be picking up the check after dinner with a portfolio company executive? Compliance officers are no longer sure whether their current practice is in line with best practice.

With that in mind, we wanted to put this controversy in better context. In partnership with Pepper Hamilton and PEF Services, we asked CFOs and other industry professionals to tell us about their current fee and expense policies.

There’s an important objective here: to provide GPs with a benchmark that allows them to compare their procedures with others. A firm that finds itself too far removed from standard practice can change its ways accordingly before arousing the curiosity of SEC inspectors. Equally, firms can remove charges typically eaten by the management firm from the budget if the industry consensus is that it should be treated a fund expense.

The tough thing about compliance is you never really know where your blind spots are until something goes wrong. That’s why CCOs are usually

quick to share their approach and rule interpretations, as a way of reaching an industry consensus on new regulations and enforcement actions. On fees and expenses, the time for that is clearly now.

What’s really going on with fees?As the SEC scrutinizes the industry over questionable fees and expenses, we set out to find what the true story is

Bowden: disclosure, disclosure, disclosure

In light of Bowden’s warning, are you now wondering whether your firm should be picking up the check after dinner with a portfolio company executive?

1,200Estimated number of private

fund advisers to have registered with the SEC because of Dodd-

Frank

25Percentage of these firms the SEC wants to examine by end

of 2014

370Newly-registered private

fund advisers now examined, according to a late September

speech made by SEC chief inspector Drew Bowden

400Number of recently registered

firms the SEC aims to inspect before its presence exam

initiative is completed

85Percentage of recently

inspected firms that received a deficiency letter, according to

Bowden

18 private funds management • Issue 123 • November 2014

fees and expenses 2014

What is the pfm 2014 fees and expenses survey?It is a benchmark to compare and review practices with others. More fund managers are asking who should pay for various fees and expenses, so we compared and reviewed industry practices.

How we created the benchmarkPEI’s Research & Analytics surveyed 104 US alternatives fund managers on their fee practices in August and September 2014.

First, we targeted CFOs to respond because they are the most informed of these practices. However, if the CFOs were unavailable, we asked

responses from other professionals, including CCOs, Controllers, and COOs, as long as they were also aware of the firms’ practices.

Next, this is a benchmark covering the US, so we reached out to firms from every region across the country. There was a high response rate from the Northeast region. This looks reflective of the market due to the private equity hubs of New York, Washington DC and Boston.

ConfidentialityWe never reveal the names or the firms of our respondents. Therefore this survey is entirely confidential.

Why alternatives and just not private equity firms?We emphasized private equity firms but also included other alternatives such as mezzanine debt, real estate, and infrastructure. For mezzanine debt, one could argue that the strategy qualifies as private equity due to the equity option of its investments. And we included real estate and infrastructure because several of these private equity firms manage a diversified platform, and more importantly, much of the SEC scrutiny facing private equity firms is equally placed on other alternative asset classes that we cover.

What type of investment firm best describes your firm below?

What is the total value of the firms assets under management?

What is the size of your most recently closed fund (i.e., no longer raising capital)?

Where is your firm headquartered?

Less than $1bn

$1bn to $2bn

$2bn to $5bn

More than $5bn20%

17%

7%

57%

Less than $100m

$100m to 500m

$500m to $1bn

More than $1bn46%

17%

19% 19% Midwest

Northeast

Southeast

Southwest

West49%

13%

9%

16% 13%

Buyout

Growth equity

Debt

Real Asset

Other24%

13%

10%

12%

40%

METHODOLOGY

DEMOGRAPHICS

Issue 123 • November 2014 • privatefundsmanagement.net 19

A pfm benchmarking survey

GPs would generally pay the legal costs through the firm itself rather than use the fund or a combination of the two

From a financial standpoint, GPs show a split in either siding with the suspected criminal party at their firm or letting him face the ramifications of decision himself.

Firm’s with less assets under management are more likely to split legal expenses through the fund and the firm

Real asset GPs are most likely to own the expenses under the firm.

Ten years ago, GPs had no way of knowing how expensive SEC

registration would become.When the commission revealed

in 2012 that it would embark on a large-scale sweep of the industry, GPs’ reactions were understandable. Some decided that the imminent prospect of inspectors showing up at the door meant it was time to lawyer up. Others began hiring compliance consultants to perform mock inspections (better to find problems during a dry run than the actual show).

But all of this costs money – and it’s never been entirely clear who should

pay. Save for all but the most recent fund vintages, GPs have generally had to rely on partnership agreements negotiated before Dodd-Frank, or at least some time before the SEC announced its grand tour.

Investors like to argue that registration is a firm expense – a cost of doing business – so the money should come out of the management fee. GPs, on the other hand, have sometimes tried to argue that compliance with the various Advisers Act rules is actually an aspect of fund business, and thus should be covered under fund expenses.

However, the results of our survey

show that for the most part, GPs are now willing to concede that regulatory exams are in fact a management firm expense. This seems logical: SEC inspectors do not necessarily target individual funds, but firm-wide operations and procedures.

“An exam is first and foremost an inspection of the firm,” agrees Julia Corelli, who co-chairs the fund services practice at law firm Pepper Hamilton. “Examiners will examine the firm’s operations and its compliance with its own policies and procedures, the advisers act and disclosures made to investors. For example, they will

PART I: REGULATORY EXAM EXPENSES

Unwelcome visitorsNo firm likes the costs stemming from an SEC examination. But some GPs are paying them anyway to placate regulators and investors

Question 1: Your firm is visited by the SEC or state regulator for a routine regulatory examination and you enlist a law firm or consultant to help guide you through the process. Who pays the legal or consulting fees?

Split between both fund and firm Management firm Fund

Total

14% 20%11% 14% 9%

33%

7%17%

78% 67% 83%68% 82%

67%

100%93%83%

100%

8% 14%6%

18%9%

Buyout$1bn to $2bn DebtLess than $1bn Growth equityMore than $5bn

Other$2bn to $5bn Real asset

AUM Strategy



check whether financial statements are being delivered in accordance with the custody rule. They will look at who the management firm signs third-party service agreements with, and test all those arrangements against what it told investors it was going to do.”

Nonetheless a number of GPs, especially at the smaller end of the market, are willing to shift the costs to the fund. Anne Anquillare, co-founder and chief executive of PEF Services, a fund administrator, says this can be explained by the fact that smaller GPs get a smaller management fee, so they’re less willing to concede the issue – and they’re more affected by w the burdensome cost of a full-blown inspection.

“The point of SEC supervision is to protect investors, so it wouldn’t be surprising to see smaller GPs use that argument to negotiate [around]

exams being a fund expense. It’s partly the case that some GPs simply can’t afford these new regulatory costs,” says Anquillare.

Post-exam expensesIf the firm is lucky, inspectors leave and no further work is required. In the real world, that’s rarely the case. We asked respondents about two scenarios in particular, to gain a feel for how GPs allocate expenses stemming from an examination.

The first, around valuation, is especially difficult because it’s largely agreed that valuing fund assets is a fund expense. But what happens if the SEC tells a firm that it didn’t get the valuations right, and corrective action is required? In this instance, more GPs seem willing to pass the cost on to investors.

“There are two sides to that argument,” says Corelli. “The first is: just because a mistake is made, the costs of redoing a valuation or other corrective action shouldn’t necessarily shift to management. GPs have to plan and operate under a fixed budget. On the other hand, investors could argue management should have gotten it

right the first time, and it was assumed during negotiations that valuation would be a one-time expense.”

Anquillare points out that valuation work is still paid for by the fund when auditors require GPs to reexamine their estimates. “So why is the logic any different when the SEC does it?”

Some GPs are likely ignoring the debate altogether and eating the cost as a way to placate the SEC and/or avoid uncomfortable conversations with investors, the two experts agree.

“There’s no right answer here,” says Corelli. “It’s going to come down to what’s fair and equitable. And that takes into account the entire fee and expense picture – how various costs are being allocated and whether or not you’d like to make a gesture of goodwill to investors by taking on expenses yourself when governing documents don’t require it.”

And if management disagrees with the SEC that the valuations were wrong? “Then you need to document why,” responds Corelli. “The firm should indicate in its own files that it disagrees with the commission’s conclusion, and explain why – but having weighed the benefits and costs of contesting the

Question 2: Say the exam leads to a deficiency finding around valuations. You decide to redo the last two quarters’ reports and deliver the new ones along with an explanatory letter to your limited partners. Who pays for the account and legal costs in getting through this correction process?


AUM Strategy

Total Buyout$1bn to $2bn DebtLess than $1bn Growth equityMore than $5bn


29% 29% 28% 33%23% 18%22%

50%

33% 33%

61% 57%56%

64% 73%

42%

78%60% 67%

67%

6% 7%11% 14% 11% 8%14% 9%

It’s partly the case that some GPs simply can’t afford these new

regulatory costs”



matter, felt it better to accommodate the request. Whether all that makes its way into an investor communication is a function of investor relations, side letter provisions – which often require it – or the governing document itself.”

The other scenario concerns what happens if a partner – say for example a deal team member who takes a seat on a portfolio company board – ends up paying settlement fees for an infraction he says was never committed. The management firm would likely

argue it’s a cost covered by the fund’s indemnification provisions (contained in the partnership agreement), which says GPs don’t take on certain legal liabilities when conducting fund business, on the reasonable assumption that they don’t act recklessly.

Corelli points out that settling the issue doesn’t necessarily mean the partner can’t be rightfully indemnified. But according to the survey, half of GPs are willing to concede the fee. What gives?

“Obviously each case is going to rest on its own facts and circumstances, but here you’ve got the management firm settling the issue. That makes it harder to turn around and tell investors to pay for something you didn’t fully contest was wrong.”

Taking the big picture view, the near even split on the question signals how broadly GPs can interpret indemnity provisions. Here, too, they probably didn’t anticipate how big a threat SEC settlements would one day become.

In proportion to time the subject principal (or others) spent on the subject activity

In proportion to the capital commitments to each fund

In proportion to the AUM of each such fund



36% 38% 38% 37% 33% 33%

50%50%

30%

50%

44% 33% 42% 47%33%

50% 50%

60%

50%

46%

15% 10%20%

29%21% 20%

33%

AUM Strategy

Question 4: How would you do the above allocation?

Question 3: An individual principal within your firm is the subject of an inquiry from the SEC which could have potential criminal or civil sanctions. He protests innocence and settles without admission of liability. Does your fund provide indemnification for his costs?

If the answer to the previous question is yes, how do you determine which fund bears which proportion of the indemnification to him?

No Yes

46%54%

Across all fundsTo all funds which are affected by the activity which was the subject of the inquiry regardless of whether the subject principal was the one who performed the activityTo the fund where the subject principal spends most of his timeTo the most recent fundTo those funds on which he works

54%

21%19%

4%

2%



by NICHOLAS DONATO

If you couldn’t make it to this year’s PE VC Finance and Compliance Forum 2014, hosted by parent

publisher PEI in San Francisco earlier this month, you missed out on the chance to catch up with Igor Rozenblit, the SEC’s most knowledgeable private equity inspector.

Indeed, Rozenblit was recently tapped to co-chair an inspections unit dedicated specifically to private funds. At our event, pfm asked him what a visit from this team of specialists would involve – and more pertinently, what GPs could do to satisfy their expectations on disclosures. Here’s what he had to say:

Precision strikes:The inspections unit consists of 13 people, including Rozenblit and his co-captain Marc Wyatt (a hedge fund specialist). As of now, the unit is based

across five offices: New York, Boston, Washington DC, Chicago and San Francisco. Interestingly, the SEC chose to fill the unit with long-time examiners who are learning the private fund model, as opposed to starting with industry practitioners and turning them into examiners.

So what does a visit from this special squad of inspectors involve? According to Rozenblit, the process isn’t all that different from a normal exam except that “it maybe runs a little bit deeper and is more thorough”. Another small difference: this team will probably spend more time on the phone before they arrive on site, asking about the firm and its inherent risks; Rozenblit said that should mean the onsite portion of the exam actually ends up being shorter and “much more focused.”

Asked whether the SEC had any plans to expand the unit, Rozenblit said that since the unit was still relatively new, “talk of expansion is premature” – although he did note that its remit currently covers virtually all of the US private fund universe.

Forget vintages:CCOs have wondered whether funds formed before 2012 – when LP best practices were still being developed and SEC registration wasn’t a requirement for most GPs – were being given more leeway. When asked about this, Rozenblit was pretty unequivocal:

“SEC examiners review advisers and their practices, not individual funds. It is therefore impossible for us to draw a relationship between fund vintage and bad conduct. Usually, but not always,

conduct is consistent across all funds, without regard to vintage.”

Last minute disclosures:We also asked about disclosures, which more GPs have been focusing on since Drew Bowden’s “Sunshine” speech earlier this year at PEI’s Private Fund Compliance Forum in New York. Rozenblit stressed the speech wasn’t intended as the “SEC wagging its finger” at the industry; quite the opposite, in fact: “That speech was based on our belief that private equity is a critical part of the US economy and is fundamentally run by good people who want to do the right thing for their investors.”

As reported on pfm, many GPs have been updating their Form ADV Part 2 with more detailed disclosures to plug any transparency gaps (on things like fees or valuation). However, Rozenblit warns that “it is not usually sufficient to provide disclosures after the fund is closed and LPs are already locked in.” So what options do GPs have if their fund is already closed? “One possible remedy would be to amend the LPA, and productively engage investors to determine a fair approach and resolution.” Interestingly, Rozenblit confirmed previous pfm reports that disclosures made to a LPAC weren’t always enough, either. “It depends on the powers vested in the LPAC by other investors (through the LPA) as well as the amount of capital represented by the LPAC,” he told the room. Needless to say, many of the attentive compliance officers present were taking copious notes.

Lessons from IgorRecently pfm interviewed the SEC’s in-house private equity specialist Igor Rozenblit. For any GP still feeling nervous about disclosure shortcomings, or the new private fund inspections unit, his message is worth listening to

The SEC’s Igor Rozenblit (left) speaks to pfm editor Nicholas Donato about a newly formed inspections unit dedicated to private fund advisers at the PE VC Finance and Compliance Forum 2014



To share or not to share lucrative deal fees – that is the big question for

GPs witnessing shrinking management fees, as investors take a tougher stance on costs. Indeed, some GPs have admitted to pfm in the past that deal and monitoring fees have been a vital cushion as they saw the prototypical 2 and 20 model dwindle to something more like 1.5 and 20 or even smaller, depending on the firm size.

It used to be the case that most GPs would offset 50 percent of transaction fees against the management fee. In recent years, however, investors have been pushing back against this practice, arguing that every dollar pulled from a portfolio company damages its exit value, and thus the fund’s total end performance. In response, most funds have been inching towards a more LP-friendly 80/20 fee sharing split, with

80 cents of each deal fee dollar returned to investors. Today, it would be fair to say that many (if not most) GPs now offset 100 percent of deal fees against the annual management fee, or avoid charging these types of fees altogether.

Large institutional investors following ILPA best practices have been especially adamant about a 100 percent deal fee offset, Anquillare and Corelli note. Smaller GPs who collect checks from high net worth investors or family offices may be behind the trend, which partially explains why there continues to be variance.

Other industry practitioners point out that an 80/20 fee split is no different from the economics in carried interest rights. After all, every dollar of committed capital spent on expenses and investments must be returned before

carry is paid, generally speaking. So assuming the fund gets to a point where carry is distributed, the offset at 80 or 100 percent is really just a timing issue.

When the portfolio company is sold, the consensus seems to be that any fees captured at the time of exit are subject to offset. The question throws up concerns about accelerated monitoring fees, which is when a portfolio company pays a lump-sum monitoring and oversight fee to the fund manager upon early exit.

In fact, just last month it was reported that one of the world’s largest private equity, The Blackstone Group, will no longer draw accelerated monitoring fees from portfolio companies.

The accelerated-fee practice was “not helpful” to the firm’s relationship with fund investors and feared the “bad perception it could engender,” the Wall

PART II: DEAL AND MONITORING FEES

Fee watchersLPs are steadily winning the battle on 100% transaction fee offsets, our research shows

Yes No

Question 5: When deal partners sit on a portfolio company board, does the company pay them director fees?

AUM Strategy



89%100%

83%79% 80%72% 77%

91%

11%

87%

17%

78%

22%13%

21%20% 28% 23%

9%

GPs generally would not have a portfolio company pay directors fees for a deal partner to sit on the board. However, most GPs expect portfolio companies to pay for a partners travel expenses when attending board meetings

While most GPs subject administrative services/monitoring fees to management fee offset, a sizeable portion of the fund managers refrain from collecting such fees.



Street Journal reported, citing a written exchange between Blackstone and one of its LPs. Blackstone is reportedly seeking $16 billion for its next flagship buyout fund.

Accelerated monitoring fees paid by

current portfolio companies will be distributed to investors, or will offset other fees by a commensurate amount, the WSJ report said.

SEC inspectors have made no secret that this is an area of focus during

exams; but what’s less clear is how much offsetting accelerated monitoring fees against the management fee influences their thinking on the matter. In any case, it’s a trend worth monitoring (pun intended).

Portfolio company Management firm Fund



33%

82%

9%9%

17%

33%12%

14% 10%13%

6%

27%

18%

36%

18%

67%

13%

27%

50%

12%

88%

60%74% 77%

94%

55% 45%

AUM Strategy

Question 6: Who pays the partners travel expenses associated with attending portfolio company board meetings?

We have never charged transaction fees like this We have ceased to charge transaction fees because of recent SEC pronouncements

80% of $1,000,000 50% of $1,000,000 100% of $1,000,000

AUM Strategy



12% 12%

11%

31%

44%

3% 2%

17%

13%58%

13%

17%

50%27%

16%

39%

19%

22%

5%

14%

14%

10%

30%20%

13%50%

6%11%

42%

75%

17%33%

67%43%

17%3%

68% 60%

Question 7: A successful bolt-on acquisition is made to a portfolio company that earns the management firm a $1,000,000 transaction fee from the deal which it shares through a management fee offset with the fund. A third party investment banker fee for the same transaction would have been, under customary market terms, $3,000,000. What is the offset you would apply to the management fee as a result of the management firm’s receipt of the transaction fee?

We do not collect such fees Subject to management fee offset Not subject to management fee offset

AUM Strategy


Other$2bn to $5bn Real asset9% 8% 6% 11% 5%

25%

45%

9%

33%

8%7%

50%

17%

51% 52%

78%

32%

58%45%

33%

33%

67%

28%

60%40% 40%

11%

64%75%

Question 8: How do you treat the administrative services/monitoring fee which the management company collects on sale of the portfolio company which has been accruing since the investment was made?



by ALLEN GREENBERG & MARK HEIL

You may remember the scene from Star Wars when Luke meets Yoda for the first time.

Challenged by Yoda to raise the space craft out of the swamp, Luke objects that it is too big. Yoda’s response is “size matters not,” and promptly moves the craft safely to land.

The initial results of the fees and expenses survey suggest Yoda’s response that “size matters not” applies to many of our industry’s practices. This surprised us given our pre-survey expectations that smaller firms would charge more expenses to the fund and larger firms would receive more fee

income at the management company. Obviously large and small funds enjoy significantly different cash flow positions, with the issue of whether certain expenses can be allocated to the fund or income directed to the management company becoming more critical as the size of the AUM decreases.

Nevertheless, we believe further study is justified. The industry is weighted toward smaller funds and the respondents in this survey were, similarly, weighted towards smaller funds: 7 percent of the respondents were from firms managing $5 billion or more and 17 percent of the respondents were between $2 billion and $5 billion. In terms of the size of the last fund raised, 65 percent were under $500 million and only 19 percent had a fund size over $1 billion.

On the surface, size did not matter whether the expenses were associated with compliance, annual meeting, entertainment, travel, deals or the practice of charging fees (e.g., transaction or monitoring).

For example, a question we thought would clearly distinguish larger funds from smaller funds:

“A successful bolt-on acquisition is made to a portfolio company where the management company received a $1 million transaction fee. The fee was below market as an investment banker fee would have been $3 million. The question was what offset would you apply to the management fee?”

As the results show (see Table 1), 17 percent of funds with more than $5 billion in AUM responded to the first choice (“We have never charged

Survey says: Size matters not?Analyzing the effects fund size may have on how GPs allocate fees and expenses results in some counterintuitive discoveries

80% of $1,000,000

We have never charged transaction fees like this

50% of $1,000,000

We have ceased to charge transaction fees because of recent SEC pronouncements

100% of $1,000,000

Buyout DebtGrowth equity

OtherReal asset

22%

10%

19%

39%30%

13%

17%

60%75%

3%

13%

5%

14%

14%

58%

68%

42%

$1bn to $2bn

Less than $1bn

More than $5bn

$2bn to $5bn

12%

27%

16%

43%17%

17%

50%

20%

13%50%

6%

11%

17%

33%

67%

2%

$100m to $500m

Less than $100m

More than $1bn

$500m to $1bn

14%

14%

15%

13%

38% 7%

6%

24%

12%

35%

64%59%

12%

12%

41%

29%

6%

AUMTable 1

Last fund size

Strategy

What is the total value of the firms assets under management?

Less than $1bn

$1bn to $2bn

$2bn to $5bn

More than $5bn20%

17%

7%

57%

What is the size of your most recently closed fund (i.e., no longer raising capital)?

Less than $100m

$100m to 500m

$500m to $1bn

More than $1bn

46%

17%

19% 19%

sponsored by PEF SERVICES



sponsored by PEF SERVICES

transaction fees like this”) as compared to 43 percent with less than $1 billion in AUM. However, 67 percent of funds with $2 to $5 billion in AUM chose this choice as well.

But, like anything else in our complex industry, you have to dig through the layers. Other factors like strategy (respondents to the survey included: 40 percent buyout, 24 percent growth equity, 13 percent debt, 10 percent real asset, 12 percent other) are influencing the responses. In this case, strategy drives the industry practice. See results on p.26.

But we were still trying to hone in on where size of a fund or firm had an impact.

An area we thought might have substantial differences is how funds of different sizes account for deal costs. Let’s take a look at this question in the survey, which read:

“During due diligence and before any letter of intent is signed, the firm hires lawyers, consultants, accountants and other service providers to begin drafting their transaction documents. Who pays for these expenses?”

As the results show here (see Table 2), if the deal closes, most funds will opt for the portfolio company reimbursement. However, size of fund comes into play

for when the deal does not close. In those instances it seems the larger the fund, the more likely the fund will bear the broken deal costs. This trend bears true across most strategies as well.

For the most part, we noticed this trend in other deal expense related questions. Not surprising. Deal expenses have been around for a long time so the best practice is due to industry experience (e.g. if the manager has to incur dead deal expenses, is there a moral dilemma for the firm to go ahead with a questionable deal rather than have the management company incur the dead deal expense?). Larger funds tend to have more institutional investors who have seen some bumps in the road due to unintended consequences of certain expense allocations.

While the SEC may be somewhat new to the private investment scene, limited partners and the school of hard knocks have been catalysts for change and enforcer of best practices for years. So, it may be that size is a factor but experience matters as well (after all, Yoda was 900 years old). At PEF, where we handle fund administration for over 125 funds of all sizes and strategies, we know that there are differences between large and small funds in terms of fees they can charge and the leverage they have in negotiating with limited partners. But we also know not to deviate from industry honed best practices. Rather, we need to take the time to explain to the newcomers the reasons why they exist. If you don’t know industry history, you are doomed to learn the hard way.

Allen Greenberg is co-founder, and Mark Heil is senior vice president of business development, at PEF Services, a fund administrator for small to middle market private capital funds.

Reimbursed by the portfolio company

Management firm

Split between both fund and firm

Fund

Table 2If the deal closes: AUM

If the deal closes: Last fund size

If the deal does not close: AUM

If the deal does not close: Last fund size

$1bn to $2bn

Less than $1bn

Total More than $5bn

$2bn to $5bn

38%29%

38%50% 50%

7%8%

15%

54%61%

38%50% 50%

1% 2%

$100m to $500m

Less than $100m

More than $1bn

$500m to $1bn

36%24%

40% 41%

7%24%

3%

50%53% 58% 59%

7%

$100m to $500m

Less than $100m

More than $1bn

$500m to $1bn

47%55%

71% 65%

41%35%

21%24%

6%10% 7% 12%6%

$1bn to $2bn

Less than $1bn

Total More than $5bn

$2bn to $5bn

57% 53%

34% 39%

72%

46%

8% 6%

11%

17%

46%

83%

1% 2%8%

17%

Like anything else in our complex industry, you have to dig through the

layers



Corporate ProfilePEF Services LLC is the leading fund administrator for small and emerging private capital funds (under $2 b in AUM), providing high-quality, cost-effective administrative solutions. We provide fund administration services for venture, buyout, mezzanine, distressed, real estate and fund of funds, with an expertise in emerging manager and SBIC funds.

Founded in 2002 by experienced managers of private capital funds, PEF Services is well equipped to meet the unique requirements of private equity fund administration. Our people have deep roots in the financial industry, including experience as CPAs, CFAs, CFOs, board directors, SBA executives, audit managers and compliance officers. We have the expertise you need to face the daily challenges of managing costs,

maintaining quality and growing the value of your fund.

The PEF AdvantageIn a professional services organization, the combination of expertise, technology and hands-on involvement is powerful. That is what PEF provides to each of its clients — complete fund administration tailored to each fund’s needs. That is the PEF Advantage.

Accounting and Investor Relations Services With PEF Services our team becomes part of your team. Clients gain instant access to seasoned professionals who understand the risk and reward of a successful fund, and proactively ensure that your fund’s back office operations are effective and efficient. We work on more than 125 private capital funds and SBICs throughout

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The annual LP meeting can be a pleasant affair. The sizzle of steaks,

the thwack of golf balls taking flight and the chance to rub elbows with other like-minded investors can be a nice break from the daily grind. More importantly, the fund usually pays for these summits – so that investors can hear an update on the fund’s performance, and listen to portfolio company executives provide their own views on how business is faring under private equity control.

However, our results show that there’s a big gray area here. For starters, not everyone necessarily agrees the fund should pay for these outings. And does it make a difference if the CEO speaking on stage is from a current portfolio company or a prospective target? Based on the mix of responses, answers become far less definitive when more specifics are given about this hypothetical annual meeting.

“Limited partnership agreements are under a lot of pressure to get not only

much more definitive on these kinds of expenses but also more consistent over the life of their fund,” says Corelli. “What we are starting to see are DDQs or shared data rooms that explain the GP’s policies and procedures more in-depth here prior to the fund closing.”

For the SEC, disclosures here may be particularly important. Industry practice is that investors pick up the tab for due diligence expenses. But it’s a matter of debate when due diligence for a specific fund investment

When accommodating limited partners at an annual meeting, the fund typically pays the bill and the management firm is the second popular option

For GPs, the fund would typically front the bill for the meals and entertainment of existing portfolio companies, while the management firm would pay for the prospective portfolio companies

For travel expenses, fund managers leave the costs on the LPs.

PART III: THE ANNUAL MEETING

Limited expenses-paid vacation!With no clear standard on who pays for various costs linked to the annual LP summit, more disclosures may be in order to satisfy SEC expectations

Question 9: At the annual meeting who pays for the travel and accommodation of CEOs of…

...prospective portfolio companies?

...existing portfolio companies?



14%

67%

3%

57% 56% 45% 55%

21%

51%

26%

13%

30% 29%

24%

41%

6%

13%

27%

53%

7%

17%

17%29%

15%

36%

18%

20%

10%

60%

10%

14%

57%

14%

9%

36%

AUM Strategy

Portfolio company from which the CEO cameSplit between both fund and firm Management firm Fund



17%33%

5%

33%26%

5%

44%

44%

32%

19%

41%

23% 23%

38%

38%

7%

50%

36%

7%

17%

50%37%

37%

19%

38%

22%

33%

44%

50%

33%

56%

3%

38%

AUM Strategy



Question 10: At the annual meeting, who pays for the travel and accommodation of the firms…

...current limited partners?



67%

1%8% 6%

77%

20%

66%

11%

22%

71%

21% 28%

67%

6%

13%

80%

7%

33% 26%

69%

23% 18%

73%

9%

22%

11%

67%

10%

70%

AUM Strategy

Management firmSplit between both fund and firm Limited partner Fund

...prospective limited partners?



40%

2%

27% 31%18%

5%

44%

68%

27%

2%

71%

2% 6%

81%

13%

77%

15%8%

60% 69%77%

11%

78%

11% 14%

86%

56%

AUM Strategy

begins exactly. As the results show, some GPs are willing to interpret the annual meeting travel costs for a target company CEO as a normal due diligence expense (and thus allocated to the fund). But the majority don’t; meaning investors may not always realize what exactly constitutes investment due diligence.

“A lot of fund managers look for a bright-line rule for when they can start to charge investment-related expenses to the fund,” says Corelli. “Now I wouldn’t say that such a bright line usually begins with talking to prospective portfolio company CEOs at an annual meeting. So disclosure here may be needed to play it safe if that is the GP’s practice.”

Open to interpretationIn other areas of the annual meeting there was an equally wide mix of opinion on who foots the bill – and

with good reason, says Anquillare.Take, for examples, who pays for the

travel costs of the LPs themselves. A percentage of GPs have the fund pay for it, because that’s how things were done in the past. But as more GPs expand the geographical reach of their investor base, the trend is “moving fast and furious” to LPs paying for plane tickets and other travel costs, says Anquillare. “It’s a reflection of the fact that it’s cheaper for local investors to attend a meeting than a LP who is travelling in from another city or country; so it’s a more even-handed way to assign the costs.”

Still, a small percentage of GPs have the fund pay for both existing investors and prospective investors to make the summit. One justification for this is that GPs are always in fundraising mode, so “it’s beneficial for existing LPs to have the fund managers always growing and reaching out to new

potential investors for subsequent funds,” says Anquillare. “Plus it gives current investors an opportunity to vet prospective LPs.”

However, an argument can be made that the benefit only accrues should existing LPs re-up, which some may choose not to. Justifying the travel costs of prospective LPs as a fund expense (so one that is charged to current investors) then becomes a little trickier. Corelli explains that GPs may be safe in doing so by staying within the confines of a fixed annual meeting budget already agreed by investors. “If the limited partner advisory committee approves, say, a $200,000 budget for the annual meeting, it’s in the GP’s discretion how that money is spent for that purpose.”

With so much complexity around who pays for what, the set budget option is particularly attractive in light of heightened SEC scrutiny, adds Anquillare. “When you start to



break expenses down to what venue is being used, or what type of food will be served, or entertainment allowed for, it becomes this incredibly time-consuming exercise. Each point may

end up undergoing negotiation. But if you have this all-in bucket, it solves that problem.”

Put differently: if the annual meeting’s main attraction is golf, and

one cornerstone investor hates the idea of wearing khaki pants and polo shirts, better to avoid the conversation altogether. After all, if you try to please everyone, nothing will get done.

Question 12: At the annual meeting, who pays for the meals and entertainment of the…

Split between both fund and firmThe limited partner Management firm Fund

...prospective limited partners?

Total Buyout$1bn to $2bn DebtLess than $1bn Growth equityMore than $5bn Other$2bn to $5bn Real asset

20%20% 19% 28%15%

55%

5%

67%

11%11%

61%

5%

14%

63%

5%

14% 13%

67%

20%

21%

43%

7%

29%

80%

9%

59%

3%

25% 22%

78%

57%

14%

29%

11%

AUM Strategy

...current limited partners?



20%

20%10% 13% 14% 5%

19%5%

40%

10%

31%

5%

54%

36%

6%

45%67%

22%

6%6%

67%

20%

13%

60% 57%

23%

6%

71%

30%

60%

10%

33%

33%

33%

50%

AUM Strategy

Portfolio company from which the CEO cameSplit between both fund and firm Management firm Fund

Question 11: At the annual meeting, who pays for the meals and entertainment (i.e., golf, tennis) of the CEOs of…...existing portfolio companies?



20%

20%9% 9% 9%

38%

14%

19%18%

9%

40%

19%

32%

42%

20%

29%47%

29%

24%

7%

27%

47%

20%

60%41%

29%

21%

29% 22%

56%

22%

14%

43%

14%

29%

18%

55%

AUM Strategy

...prospective portfolio companies on which diligence is being performed?



20%

20%

20%

7% 8%15% 17%

3% 10%

24%

19%

13%

56%

19%

19%

62%

15%33%

47%

20%

50%

14%

29%

7%

40%

50%

30%

48%

13%

75%

13% 17%

67%

17%

13%

50%

25%

AUM Strategy



One of the biggest challenges faced by private fund advisers is figuring

out at what stage of the acquisition process the fund begins paying for all the associated due diligence and deal expenses like lawyer fees and consultancy work.

Legal experts are quick to say there is no right answer here, and that everything depends on a reading of the partnership agreement and

marketing materials. Even then: “The fund’s governing documents are rarely granular enough to provide a direct answer here,” says Corelli. “Often you could make arguments either way that any given deal expense should be charged to the management firm or fund.”

Assuming most LPAs all include more or less the same basic language, it’s not entirely surprising to see the

wide variance in how these expenses are actually being allocated. Some GPs are comfortable charging the fund due diligence costs as soon as they begin meeting with CEOs of suitable target companies; other GPs continue paying for accountancy and consultancy fees even after a letter of intent (LOI) is signed with target management.

“What makes these results so interesting is that the signing of the

Question 13: Who pays the cost for firm partners to attend private equity industry conferences (i.e., conference tickets, travel) in which they expect to…


...meet CEOs of suitable target companies?

...learn economic trends, legal and accounting issues?



83%

2% 3% 5%

100%91%

2%

7%

90%

8% 11%

83%

6%

100%

17% 3%

94%

9%

86%

25%

75%

11%

89%

AUM Strategy



67%

4% 9%

74%

4%

22%

76%

20% 29%

65%

6%

14%

86%

33% 29%

63%

23% 25%

75%

13%

88%100%

77%

AUM Strategy

PART IV: DEAL COSTS

Blurred linesDespite investors and regulators taking a hard look at the various charges racked up during the acquisition process, as well as dead deal costs, GPs still seem to be all taking their own approach as to how these expenses are ultimately shared

When accommodating limited partners at an annual meeting, the fund typically pays the bill, and the management firm is the second popular option

For GPs, the fund would typically front the bill for the meals and entertainment of existing portfolio companies while the management firm would pay for the prospective portfolio companies

For travel expenses, fund managers leave the costs on the LPs.



LOI was really the only true bright line test ‘back in the day’,” says Anquillare. “Clearly, we’re seeing some drift as the industry matures and the amount of diligence required increases along with the expense. Overlay the SEC’s focus on fees and expenses, and we are going to see some shifting over the next few years until we get to a new norm.”

Investors of course prefer seeing the management firm eat as much of the acquisition costs as possible. For

instance, when it comes to industry conferences, the argument from LPs is that the management fee is, in part, paid so the GP can find and retain top industry talent. GPs should have some level of market education and stay on top of industry issues as part of their fiduciary obligation to investors, the reasoning goes.

The counterargument, made by particularly bold GPs, is that industry conferences and other networking

events provide indirect benefits to the fund (say that day two morning panel led the GP to sniff around deal opportunities in Turkish real estate), and are accordingly a fund expense. Shaking hands with a target company CEO at one of these conferences makes more fund managers comfortable with that line of thinking (see question 13).

One clear lesson from the results, though, is that as GPs go further along the acquisition process, and hone in

Question 15: During due diligence and before any letter of intent is signed, the firm hires lawyers, consultants, accountants and other service providers to begin drafting their transaction documents. Who pays for these expenses?

Question 14: After meeting at an industry conference, a partner takes a target company CEO out to lunch. Who pays the tab?

Portfolio company Management firmSplit between both fund and firm Fund



1%

68%

28%

2%

75%

75%

25%13%

33%

50%33%

67%

44%

56%

71%

24%

80%

10%

10%7%

87%

7%

33%

61%

13%17%6% 5%

AUM Strategy

Reimbursed by the portfolio company Management firmSplit between both fund and firm Fund

If the deal closes:

If the deal does not close:



50%

2%

56%

11%

33%

7%

54%

1%

38%

61%

29%

8%50%

50% 46%

15%

38%50%

31%

69%

23%

18%

59%

42%

50%

8%67%

11%

22%

AUM Strategy



17%6%2%

14%

34%

8%1%

57%

39%

53%72%

11%17%

46%

8%

46%

83%58%

28%

73%

42%

8%

50%

56%

44%

11%

44%

44%

9%18%

AUM Strategy



on a specific target company, the more agreeable it becomes that due diligence costs and other related expenses become chargeable to the fund. For instance, before a letter of intent is signed, 34 percent of firms managing less than a $1 billion in assets under management eat consultancy and legal fees that come with drafting transaction documents at the management firm level. But after that next step is taken, and a LOI is signed, only 22 percent of respondents are willing to take on due diligence expenses internally. Take it another step, with a definitive agreement signed with target portfolio company management, and the comparative percentage drops to 16 percent. Interestingly, some firms are willing to eat dead deal expenses even at this level, which in certain circumstances speaks to the fact that these costs can sometimes be up for debate, even during the later stages of the acquisition process.

Finding safe groundAll that said, what‘s the SEC’s position

on the matter? Are GPs taking on any kind of compliance risk by charging investors for private fund conference tickets?

As always, the issue usually boils down to disclosures, says Corelli. “Outrightly telling investors that trade conferences are fund expenses – and getting no pushback on it – would seem to put you in safe territory.”

“On the other hand, disclosure can’t be the only solution,” Anquillare adds. “If GPs have to break down every nickel and dime of fund expenses, partnership agreements and footnotes will become unwieldy.”

Being under the SEC’s microscope can also help explain why some fund managers take on the costs of a broken deal even after a definitive agreement is signed with target management (where perhaps financing for the acquisition later fell apart), says Corelli. “Dead deal costs are getting a lot of regulatory attention. There are some GPs who say: ‘Let’s just eat this so we don’t have to decide how to channel the costs

Question 16: After a letter of intent is signed, the firm hires lawyers, consultants, accountants and other service providers to begin drafting detailed transaction documents. Who pays for these expenses?

Reimbursed by the portfolio company Management firmSplit between both fund and firm Fund

If the deal closes:



50%

2%

50%

40%

10%

4%

57%

2%

36%

65%

29%

4% 44%

56% 50%

7%

43% 50%28%

72%

32%

9%

59%

25%

67%

8%78%

22%

AUM Strategy


AUM Strategy



12%2% 11%

22%8%2%

68%

22%

65%83%

6%11%

57%

43%

100%75%

14%

82%58%

25%

17%

56%

44%

10%

40%

50%

5%14%

If GPs have to break down every

nickel and dime of fund expenses,

partnership agreements and

footnotes will become unwieldy



Question 17: After a definitive agreement is signed, the firms financing team and the portfolio company CFO negotiate financing for the deal. Who pays legal fees incurred by the lender?

Reimbursed by the prospective portfolio company

Split between both fund and firm

Management firm Fund

If the deal closes:



83%57%

70%

1%

27%2%

76%

22%2% 39%

61%77%

23% 17% 19%

81%

24%

76%

25%8%

67%

43% 43%

57%

AUM Strategy


AUM Strategy



33%16% 14%18%

16%

1%

65%

16%

69% 67%

6%

28%

62%

15%

23%

67% 71%

14%

75%58%

25%

17%

50%

38%

13%

29%

14%

57%

15%10%

and risk inspectors grilling us over whether it was appropriate’.” Caution is warranted, Corelli warns, since doing so creates precedent.

Anquillare mentions that having the firm pick up dead deal costs also stops investors from picking up the phone and “raking the GPs over the coals” for a collapsed deal that could have exhausted significant fund dollars. Indeed, deals further along the acquisition process may be more clearly fund expenses, but they also rack up bigger legal, accounting and consultancy bills, making it harder for LPs to swallow when a fund investment doesn’t materialize. “But we shouldn’t forget why funds historically have picked up dead deal costs,” she adds. “It’s better for both GPs and LPs to walk away from a bad deal than to go forward just because you have a lot of due diligence dollars spent.”

On a related note, one interesting practice is the decision by many GPs to charge these costs to the portfolio company. On first blush, it may not

seem to ultimately matter if costs are allocated to the fund right away, or materialize later by virtue of sending them to a portfolio company that theoretically fetches lower returns upon exit. Assuming the deal goes through, the economics are the same. But Corelli and Anquillare point out that GPs rarely own 100 percent of the company or an asset, meaning an expense pushed to the portfolio company allocates some of the cost to other owners. There are tax considerations too. Portfolio companies, as corporations, may be able to treat the same expense given to the fund as tax deductible (in fact entire businesses have cropped up to exploit these tax efficiencies).

In the coming years, our two experts agree, LPs will take an even greater interest in how firms allocate deal costs. It’s possible GPs will begin standardizing how some of these expenses are shared; after all, there’s safety in numbers. But until then, Corelli and Anquillare expect firms’ defense strategy here to continue to be: more disclosures.

There are some GPs who say: ‘Let’s just eat this so we don’t have to decide how to channel the costs and risk inspectors grilling us



by JULIA CORELLI

The environment in which fund managers must operate currently is about as

challenging as any since the inception of the private equity industry. Perhaps it is a natural outcome of a maturing industry, or perhaps the over exuberant swing of the pendulum, but today’s combination of market values, competition for investment opportunities, external pressures from investors, internal pressures for talent and succession, regulation and regulators’ enforcement mentality are pretty unique. There is no doubt now: operating in the private investment industry, whether it is PE, venture, hedge, real estate or other alternatives,

requires careful planning, meticulous execution and a really good crystal ball. It is not for the fainthearted.

One element of operations that has become very clear through the regulatory examination process is that fund managers need to have the ability to foresee all the needs of their management of the funds at the outset and to disclose those needs clearly in their private placement memoranda. Investors are more and more focused on the cost of their investment and the way those costs can go up in unexpected ways. Putting too heavy a cost burden on the fund, i.e. making too many expenses be borne by the fund, will make fundraising very difficult even for the most seasoned manager.

Then again, not being aggressive enough in expense allocations can make the management firm unsustainable, particularly in the back half of the fund’s life when management fee revenue typically declines. So fund managers inquire of their friends and advisers – what do you do about “X.” how would you treat “Y.” Overall, there is very little in the way of any formal guidance on what kinds of expenses should be fund expenses and which shouldn’t. There is only the “one-size-fits all” guidance. It is all high level. So PEF, Pepper and pfm conducted this survey to try to highlight nuances that every fund CFO and CCO must manage.

Working backwards from lessons learned from the examination and enforcement arena, it is clear that definitive disclosures and living by what you said you were going to do

are the only certain way to make both regulators and investors happy. So careful planning for the expected and leaving room for fair, equitable and consistent treatment of the unexpected, along with clear documentation of the rationale for treatment of the gray zone, is the only way to go. But how is a fund manager to predict the changes in the deal world? Or changes in an investor’s need for liquidity and the pressures that brings on the manager?

Take the auction process for deals and how that has changed over the past decade, driven largely by the increased competition for good investments. At the risk of overgeneralizing, more expenses are incurred earlier in the process than a decade ago, there are generally more participants, and they generally have to submit full mark ups of documents before they are a finalist. That, by definition, means more

The new realityThe industry may be at a turning point on fees and expenses. At any rate, expect compliance staff and legal counsel to beef up disclosures and more carefully document the cost allocation process

Corelli: providing context on the big fee debate

The need for crystal clear disclosures and

fund agreements is more apparent

than ever

sponsored by PEPPER HAMILTON



broken deal expenses for any fund that participates in auctions, unless the management company absorbs more of the costs. While investors may like management firms to do so, having that kind of variable expense in the budget is unmanageable for all but the largest firms.

The answer may be an expense cap for the fund, or a cap on broken deal expenses, but investors have not yet gone there in the market due, I expect, to the disincentive that may place on managers who get close to the cap.

Some firms manage some legal costs by bringing advisers in house and gaining control over the line item for legal fees on deals by having in house folks do initial deal work. But then they lose the benefits of expertise that outside counsel can bring, so they supplement with outside counsel and that seems to be the happy medium, but no guarantee that even the outside counsel expense is a fund expense unless it is clearly made so in the fund’s governing agreement. Despite valiant efforts to predict how each transaction in which the fund invests or proposes to invest over the life of the fund, and no matter how great the draftsmanship in addressing each such type of expense, Murphy’s Law is such that it will not work in every situation.

Take consultants, for example. A fund agreement may provide that the management company can retain consultants to assist in evaluating a deal and charge their fees to the funds. If the deal does not ultimately close, a significant group of surveyed managers said the management firm pays the consultant’s fees.

There is some understandable irritation in this for investors as the larger the funds or the AUM, the less likely the management firm is to pick up the costs of the consultant in a

deal that does not close, even though they, arguably, should have better infrastructure to withstand the cost. If there were comparative data available for 5 or 10 years ago, would the result have been the same? I would submit that it would have shown more being picked up by the funds. Two large reasons for the change are investor pressure on costs and changes in the way deals are often done nowadays.

Another change looming large in the night terrors of fund managers is regulatory expenses. Not so much the costs of registering as an investment adviser, nor the costs associated with being examined, but the cost of arguing, respectfully, of course, with regulators that there was not a violation. Initially, fund managers and investors did not disagree that the costs of registration were a management company expense as well as the costs of any examination or deficiency correction. This has heightened the scrutiny on both expense provisions in fund agreements as well as indemnification provisions. If a firm receives a deficiency letter from a routine examination claiming that certain costs should not have been fund expenses because they were not adequately disclosed to the investors that they would be so treated, and the firm pushes back and prevails in its view that it has treated costs appropriately, should those costs be fund expenses under the fund agreement and if not, should they be indemnified under the indemnification provisions? We did not ask this specific question in the survey, but given the results (on p. 24 of the November issue of pfm), what would your answer be?

On the one hand, it is logical that the firm agrees to bear examination costs when the fund agreement refers to regulatory costs being management company expenses. On the other hand,

the back door effect of indemnification is something to be cautious about for investors who would not expect the fund to pick up these expenses.

Overall, the need for crystal clear disclosures and fund agreements is more apparent than ever. That, and real-time documentation of decisions on how to treat expense items, and consistency in the application of the firm’s principles about expenses, are the only almost-sure-fire ways to avoid a misunderstanding between the firm and its investors or between the SEC and the firm.

Julia Corelli is a partner with Pepper Hamilton’s corporate and securities practice group and co-chairs its funds services group, a core constituent of Pepper’s Investment Funds Industry Group (IFIG).

Fund managers need to have the ability to foresee all the needs of their management of the funds at the outset and to disclose those needs clearly in their private placement memoranda

sponsored by PEPPER HAMILTON



Pepper Hamilton LLP is a multi-practice law firm with more than 500 lawyers nationally. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world.

Our Funds Services Group is composed of more than 50 lawyers from multiple and diverse practice areas. With judgment honed from representing hundreds of pooled investment vehicles over more than two decades, we have helped both U.S. and international funds and their sponsors, managers, advisers and investors define and achieve their goals.

The investment industry has experienced unprecedented regulation in the past few years and it can be challenging to adapt to a new regime of transparency, accountability and enforcement. We consider it our responsibility not only to know the law but also to understand the investment management market – where the pendulum is and where it’s likely to

swing. Our Fund Services Group has commented on regulations in development and speak and write about them after adoption. We connect and discuss experiences with professionals in virtually all corners of the investment management industry. We provide input and commentary to the initiatives of various trade associations, such as NVCA, SBIA, PEGCC, and the ABA. As a result, we stay connected to the markets in which we and our clients work and are experienced and well-positioned to advise our clients about practical adaption to the new environment.

The Funds Services Group is a core component of the firm’s Investment Funds Industry Group, which is an interdisciplinary industry group comprised of more than 60 lawyers nationwide who focus their practices in areas vital to the success of all types of investment funds throughout their entire life cycle, including with respect to formation, transactional and investment, operational, and regulatory and compliance matters. The Fund Services Group within IFIG includes

experienced investment management, corporate and securities lawyers, seasoned regulatory lawyers (including veterans of the asset management industry, the SEC, FINRA, the United States Department of Justice and other agencies), and tax and employee benefits lawyers, who regularly work with the issues that arise from different fund structures, different fund strategies and different investor bases.

We have the added advantage of being able to draw upon a full panoply of specialists at Pepper to deal with issues our fund clients encounter during their life cycle, including, technology, litigation and litigation-risk mitigation, government investigations and white collar defense, FCPA issues, FATCA compliance, CFTC matters, energy and environmental regulation, information management, privacy, governance, shareholder activism, and public securities regulation.

Our collective and singular focus is to help clients successfully navigate the legal landscape in which they operate so as to achieve their mission.

Pepper Hamilton LLP

Julia D. [email protected]

Edward T. DartleyOf [email protected]

P. Thao [email protected]

Stephanie Pindyck-CostantinoOf [email protected]

Contact


Too much regulation can have an interesting impact on industry

practice.As the SEC scans the industry

for bogus fees and expenses, they’ve taken issue with operating partners on portfolio company boards who draw lucrative directors’ fees.

The SEC reasons that management fees are already funding the firm, and the firm should be paying these partners for their work – so why are GPs double-dipping by having portfolio companies pay a second salary?

“The bottom line is GPs are meant to monitor and improve portfolio companies. So the SEC says you can’t just

send one of ‘your people’ down there to take a board seat, be paid a director’s fee, and save yourself his or her remuneration at the management company,” explains Corelli.

Accordingly GPs typically either don’t allow portfolio companies to pay their partners directors’ fees, or they offset any remuneration paid to their people for serving as directors against the annual management fee.

However, this same logic is being applied to operating partners that take a portfolio company board seat but who aren’t really employees or partners of the firm. Often private equity firms will have operating specialists on retainer,

meaning they’re on call for feedback and advice when needed. These retainer fees may only be as little as a couple thousand dollars per month, but sometimes it can be enough for the SEC to consider them working members of the management firm. The problem arises when one of these operating specialists take a board seat at one of the firm’s portfolio companies (perhaps they felt it was a really great investment) and begin drawing six-figure fees or possibly more.

“What happens then is that operating specialist’s fee income or salary might have to be offset against the management fee,” says Anquillare. “We’re talking about potentially millions of dollars in

PART V: OPERATING PARTNERS

When value-add goes wrongNervous that the SEC may strip them of management fees, GPs are exercising restraint when appointing operating specialists to portfolio company boards

GPs are split when it comes offsetting operating partner director fees against the fund management fee, but only a third would continue to offset fees if the retainer is paid but then ceases

Knowledge of a consulting firm paying the operating partner makes little difference for GPs

GPs generally would not offset any equity options that the portfolio company granted to the operating partner against the fund management fee. For those who would, the typical offset amount would be drawn from the net cash received from the option shares upon exit

Question 18: Assume an operating partner on retainer with your firm joins a portfolio company as an independent director. Would you offset the operating partners cash director fee against the funds management fee?

If you answered yes to the previous question, if the firm ceases to pay them the retainer would you offset the operating partners cash directors fee against the funds management fee?

No

Yes49% 51%

No

Yes

33%

67%



lost fees here because a $5,000 a month or so retainer fee for their services brought them under the firm umbrella.”

One of the SEC’s concerns is that these value-add experts or sector specialists on retainer are being portrayed to investors

as full-time members of the management firm, when in reality they have a much more limited scope. The title “operating partner” can in itself be confusing to LPs, who may mistakenly invest in a fund under the belief that the firm has

certain staff dedicated to operational value-add.

In fact, operating partners who are portrayed as employees of the management firm but who are actually compensated by the fund or portfolio

Question 19: Would you offset any equity options that the portfolio company grants to this operating partner (for services as an independent portfolio company director) against the fund management fee?

If you answered yes to the previous question, what is the amount of the offset?

No

Yes

32%

68%

Net cash received from the option shares at exit from the investment

Value at time of grant

Value at time of exercise

37%48%

15%

Question 20: If the portfolio company pays consulting fees to the operating partners company and the operating partner owns 25 percent of the consulting firm, would you offset the consulting fees paid to the consulting business against the management fee?

Yes,in total Yes, in the amount of 25% of the fees Not at all

Would knowing what the consulting firm actually pays the operating partner make any difference to you?

Yes No



24%

19%

57%

33%55%

18%

27%

67%

60%

40%48%

33%

20%

70%

15%

15%33%

22%

44%

22%

11%

67%92%

8%

57%

36%

7%

AUM Strategy

AUM Strategy



28%

72%

67%50%

50%33%

25%

75%61%

39%

89%

11%28%

72%

33%

67%92%

8%

86%

14%



company is one of the most common deficiencies cited during presence exams, SEC chief inspector Drew Bowden said at the PEI Private Fund Compliance Forum in New York earlier this year.

Bowden specified that exam staff find these types of professionals often work exclusively for the manager from an on-site office; they invest in the manager’s funds on the same terms as other employees; and they can even appear on the firm’s website and fundraising materials as full members of the team.

So there’s a bit of a dilemma for GPs here. It seems unfair that an operating specialist called a few times a month results in such a loss of management fees. But in light of all the recent SEC rumblings, the safe bet is to offset their director fees. What we wanted to gauge, then, is which of these less-than-ideal options GPs are actually pursuing.

Question 18 results show a nearly even

split in response, indicating the level of uncertainty around the issue. Take away that retainer fee, however, and more GPs are (as one would predict) fine with

leaving management fees alone.From there, we tweaked the scenario

to test what kinds of factors might result in GPs landing one way or the other on the issue. For example, if the operating specialist on retainer also happened to

own a slice of the consultancy firm the GP entered into contract with as well, that might bring the operating partner more under the firm’s umbrella, such that an offset would seem more appropriate.

In a worst case scenario, what this could mean is that private equity firms abandon this type of value-add strategy in order to preserve management fees. But Corelli says the more likely scenario going forward is that more PPMs and other fund documents will discuss operating specialists in more detail “and better clarify the terms of the relationship with the management firm”.

Indeed, it’s a changed world since registration became a requirement for many firms back in 2012. And now that investors and regulators have jointly pushed a spotlight on fees and expenses, future fee and expense benchmarking exercises may reveal that more of a standard is developing. Stay tuned.

We’re talking about potentially

millions of dollars in lost fees here because

a $5,000 a month or so retainer fee for

their services brought them under the firm

umbrella

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Date post:	21-Apr-2018
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