Our full academic paper on this topic is forthcoming in the Journal of Financial Economics.
The working paper version is available for free here.
The key question, in plain English, is: Are portfolio company fees (fees charged by GPs to companies they control with Other People Money) excessive?
GPs charge for having organized the purchase of the asset (transaction fees), for monitoring this asset (monitoring fees) and additional fees whenever they do something (e.g. debt restructuring, add-on acquisitions etc.) They argue that this is fair compensation for work, and therefore, these fees are not excessive / cannot be seen as profit.
Our comprehensive study found many empirical facts that are more consistent with the idea that these fees are a pure profit center, i.e. excessive:
There are large differences in the amount charged by GPs (some charge zero, some charge a lot), and these differences are not company specific but GP specific (when a company changes GP, fees charged are different). Hence, it is unlikely that fees are related to work done (else that would imply that some GPs are not working at all!), more likely to be a GP choice/decision/preference.
These fees are also unrelated to performance, so they are unlikely to be related to the amount of work performed.
The contract (MSA) explicitly says that monitoring fees do not require any work to be performed for them to be paid. Transaction fees are more vague but contracts usually explicitly specify that any actual work performed in relation to the transaction can be invoiced separately as an expense. Hence the transaction fee is more like a show-up fee.
Most LPs (whose money it is) were not aware of these fees, not informed of the amount… pre-2010. Post 2010, work such as mine, that of the SEC, journalists, brought them to the attention of most LPs. GPs charging the most of such fees pre-2010 raised less capital post-2010 given their track record, indicating that LPs reacted negatively to prior fee practices once made aware of them. If the fees were fair compensation for work then LPs would have not shown any reaction, i.e. would not have altered amount committed to GPs as a function of how much they charged in the past in portfolio company fees.
Most of the fees are refunded to the LPs. The fraction refunded depends on the GP. Those refunding the most tend to be those charging the least and the fraction refunded is unrelated to performance. If fees are compensation for work, why are they refunded to LPs? And why would the fraction refunded vary across GPs… Again, most consistent with the idea that it is a GP preference/choice.
As LPs became more aware of these fees, fraction refunded increased towards 100%. Why would it be so if it was compensation for work? If they are 100% refunded, then the work has not been compensated. If it is compensation for work, GPs should keep all the money
From economics theory/intuition, if the situation is that an agent decides on how much to pay itself (remember GP controls the asset with OPM) then the agent is likely to pay itself a bit too much rather than too little. There are piles of empirical evidence on this in different settings in the Economics academic literature.
Why are these fees still charged now that all LPs are aware of them?
GPs are in a strong bargaining position and prefer to charge this way rather than increasing the headline fee, which they post at 1.5% – 2.0% with 8% hurdle, which smells reasonable/standard.
It is tax efficient (which can be relabelled depending on one’s angle). Given that tax authorities accept the argument that these fees are operational expenses, then a GP should actually not charge any management fees to LPs and derive all of their income directly from portfolio companies. This way all of the costs and profits of the GP are deducted from corporate taxes of portfolio companies and LPs need not pay any management fees and fund expenses. In this case, LPs are better off (as long as the amount is contracted upon ex-ante and is verifiable).
On the tax front, we found that even companies not paying any taxes pay portfolio company fees. Hence, it is not a purely a tax-motivated decision by GPs. Again, more likely to be down to GP pref/choice.
Note that many companies do not pay corporate taxes, especially while in PE hands, hence there may not be enough tax savings to justify a full shift of fund management fees to portfolio companies.