by Will Ashworth | April 17, 2014 11:35 am
Here’s a shocker: Private equity firms charge unjustified fees to the companies they’ve acquired and don’t bother to tell their investors.
This revelation comes courtesy a review of 400 private equity firms by the SEC. While this might be a surprise to the average Joe investor on the street it shouldn’t be news to anyone who follows private equity. Firms like Blackstone (BX) and KKR (KKR) have been pulling these kinds of shenanigans for years.
Where does it all stop?
Regardless of how you feel about Jim Cramer, his take on private equity is right on the money. Private equity firms are concerned with their paycheck above all else — including the very companies they own. The truth is that private equity firms are established specifically to generate substantial revenue through fees charged for consulting and other services along with traditional fund management fees and carried interest. They don’t care about much else.
Not convinced? Let me show you three examples of IPOs in 2013 that were sponsored by private equity firms and charged fees that are fairly easy to construe as unjust.
Peter Yesawich is a travel marketing expert with MMGY Global. In 2009, Yesawich had this to say about Blackstone’s $2.7 billion purchase of Busch Entertainment Corporation: “SeaWorld probably will sleep better at night knowing it has Blackstone’s backing, resources, and its keen understanding of the industry.”
Given that Busch was on the market as a result of its parent company’s sale to InBev; its acquisition by the private equity firm definitely ended the uncertainty surrounding Shamu’s future.
That said, it didn’t come without a cost. When SeaWorld (SEAS) was sold to Blackstone it had zero debt. One year later, the theme park was saddled with $1.4 billion in long-term obligations and an annual interest expense of $134 million. On the fee side of the ledger, SeaWorld entered into an advisory agreement with Blackstone that paid it $17 million over three years for strategic and structuring advice and another $47 million to terminate the agreement upon going public in April 2013.
It’s one thing to saddle the company with debt. It’s another to charge $64 million over three years for services that should have been provided for free in its role as owner. If that’s bullying your way to profits, I don’t know what is.
Bain Capital, Carlyle Group (CG) and Clayton, Dubilier & Rice acquired HD Supply (HDS) in 2007 for $8.5 billion ($2.3 billion cash and debt for the rest), with Home Depot (HD) retaining a 12.5% stake in its former subsidiary. That’s about average in terms of private equity leverage, so there’s nothing unusual about the transaction itself.
However, HDS did agree to a sponsor management fee which paid the trio of private equity firms a combined $5 million annually to watch over their own investment through 2017. That’s approximately $30 million in fees over the past six years.
In June 2013, as part of its IPO, the company paid an additional $11 million to the private equity sponsors for a transaction fee and $18 million to terminate their management fee four years early. In total, the trio of firms received $59 million over six years simply to play babysitter over their own investment.
I have no idea whether any of these funds got to investors or not, but once again you’re looking at private equity firms playing both sides of the street. It’s not illegal, but it certainly smacks of greed.
By now I’m likely sounding like a broken record, and you’ve probably figured out that management, transaction and termination fees are standard practice in private equity circles. Every buyout includes these fees in the acquisition agreement. However, the history behind TPG Capital’s involvement in Quintiles Transnational Holdings (Q) makes this a little less mundane than your garden-variety buyout.
One Equity Partners, the private equity arm of JPMorgan (JPM), acquired Quintiles in 2003 for $1.7 billion. One of the minor PE firms investing in the buyout was TPG, who invested $90 million in equity. Four years later, TPG and Bain Capital bought One Equity’s stake for $3 billion, with TPG investing another $424 million in equity, which means it spent $514 million prior to Quintile’s IPO in May 2013.
But don’t feel sorry for TPG. It got a lot more than it gave, including $147 million in the IPO, $266 million in additional stock sales, $345 million in dividends and $12 million in management fees. And its remaining 17.9 million shares are worth $900 million as of April 9. That’s a total of $1.67 billion TPG managed to scrape from Quintiles.
So, what should investors take away from all of this? Well…
In the traditional two-and-20 fee structure that private equity firms employ for each of their funds, it goes without saying that investors in those funds accept this arrangement with open eyes. It also stands to reason that these investors, many of whom are institutional in nature, and fully capable of understanding the ancillary fees that might flow to private equity firms in the course of their 5-7 year commitment.
Harder to understand is how private equity firms are allowed to play fast and loose with management fees against the acquired company. In the case of Quintiles, TPG has probably generated $225 million in carried interest (realized and unrealized gains of $1.6 billion less $514 million equity times 20% performance fee) plus $10 million annually from the 2% management fee.
The total take for the two-and-20 fee structure comes to approximately $300 million, most of which was earned over the last six years since it acquired control from One Equity. Yet despite this largesse, private equity firms seek to extract even more for themselves by also charging management fees to the companies they’ve acquired plus hefty one-time termination fees. In the case of TPG it comes to $12 million, which in the scheme of things is peanuts, but it’s money just the same that pension funds could use.
Private equity is bullying its way to big profits. It’s time the SEC brought that to a close.
As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.
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