Private equity firms have charged hidden fees amounting to USD20 billion to companies, while some of the firm’s partners have sat on the company’s board of directors, according to a new study.
Dr Ludovic Phalippou, Associate Professor of Finance, Saïd Business School and his co-authors Dr Christian Rauch and Professor Dr Mark Umber examined the portfolio fees of 592 US companies worth USD1.1 trillion in total. In a new paper “Private Equity Portfolio Company Fees” they reveal that these companies paid a total of USD20 billion to private equity firms over the last twenty years.
Dr Phalippou said the study raised questions about what these fees are for: ‘It was odd for us to read that it is quite common for board members to claim various expenses and consulting fees to a company that they supervise,’ he says. ‘We decided to have a close and systematic look into this.’
The paper found that the monitoring and transaction fees were not related to business cycles, credit cycles, or to company characteristics. When these fees became news and were subject to US Securities and Exchange Commission (SEC) investigations, firms charging the least raised significantly more capital than they did before the financial crisis.
‘People speculated over the summer that these fees could be a tax evasion scheme,’ says Dr Phalippou. ‘But we are sceptical of this explanation because we found that half of the companies pay no corporate taxes, even before these fees are charged and the fees are not sensitive to the earnings before tax of a company.’
During the 2008 financial crisis the providers of capital complained about these fees and as a result many general partners (GPs) announced they would refund 100 per cent of these fees going forward. However, the paper claims that even when a refund of 100 per cent is mentioned, the effective refund may be less. There are restrictions and further complications in those calculations which effectively reduce the rebated amount. Even if these fees were to be 100 per cent refunded to investors going forward, the paper shows that the amounts charged are economically relevant and significantly impact the finances of a large number of companies.
Accelerated monitoring fees have attracted the most regulatory and media attention. But the research shows that they are basically only charged by companies going public and at the time of the initial public offering (IPO). If monitoring fees are accepted practice, then it is difficult to see why a fee charged at the time of the IPO which covers the monitoring of the general partner would not be accepted, argue the researchers.
Dr Phalippou, says: ‘From these findings the SEC may need to review their current approach. These practices are either legal or not. If they are deemed illegal then the SEC should target big offenders with large fines. Our results indicate that the GPs that the SEC seems to have targeted so far are more “big names” than “worst offenders.” Hopefully, this first paper to study portfolio company fees and management service agreements will catalyse further research and debate in this field.’
