Wednesday, August 24, 2016

Opinion on Private Equity monitoring or accelerating fees enforcement

The talk of the town this week is the $52.7 MM settlement paid by Apollo Global Management.

This came on the heels of a biased study designed to malign the industry from CEPR (Center for Economic and Policy Research) published in May 2016 (Link to pdf)

The "accelerated services and evergreen" fees are stipulated in the Management Services Agreement (MSA) which the authors of the study Eileen Appelbaum and Rosemary Batt call "egregious" and "money for nothing". To begin with, the authors blatantly disregard that MSAs are different from company to company and unit to unit. The authors blames private equity for cashing in the evergreen fees if they sell the company before the 10-year end of an MSA. The authors are likely to have a poor grasp of the concept of unrealized gains and losses. If indeed the MSA allowed for a retroactive payment of monitoring fees as non-refundable, then they were a "better than expected" provision signaling a faster, unexpected outcome for the portfolio company. You pay extra for an early success.
"Whatever they're paying you, I'll double it" -we heard it  thousand of times: the extra is for working ahead of schedule.

Those same authors take up the false logic that GP "may be motivated to carry out transactions that generate substantial fee income" in disregard to the PE Fund and LP interests. That is a prima facie ridiculous conclusion, since how can LPs make more that GPs when they share profits ? "Ex ante financing can alleviate some of these problems. By tying the compensation of the GP to the collective performance of a fund, the GP has less of an incentive to invest in bad deals, since bad deals will contaminate his stake in the good deals." [Why are Buyouts Leveraged? - The financial structure of private equity funds, by Ulf Axelson, Per Stromberg, and Michael S. Weisbach, December 14, 2007. ]

As Nick Leopard of Accordion Partners wrote today, when a 100 day value creation plan is set in motion, milestones and KPIs need to be reached and company-sponsor joint accountability becomes essential. In Apollo case there was rogue element, a former employee who diverted funds for personal use and who left the company in 2014.

The cited study has a problem with reinvested carried interest. It also criticizes the monitoring fees as "disguised dividends".  No, they are not. See Duanee Morris PE fund_distribution_waterfalls.pdf  "General Partners and Investors often take the approach that dividends and interest income should be included in the calculation of the Carried Interest based upon two theories: (i) that Investors’ returns should be based upon a cash-in, cash-out model, including dividends, interest, payment of management fees, and organizational expenses, and (ii) failure to include dividends and interest from the Carried Interest causes a misalignment of interest between the GP and the investors."

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