Monday, June 15, 2015
Explaining Disparities in Professional Fees Charged Private Equity Funds
Gretchen Morgenson wrote a column in yesterday's New YorkTimes regarding differences in the fees that outside professionals charge private equity funds and their portfolio investments and the fees they charge the fund sponsors. As with all Morgenson columns, she would have the reader perceive that she is bringing to light a secret, nefarious and unethical practice. Never mind that she acknowledges that she learned of these differences from disclosures in regulatory filings, and that it is axiomatic that conflicts of interest are not inexorably disabling, they can be consented to. And also never mind that the scale of the purported conflict is probably microscopic, given that external professional fees rarely make a material impact on an asset manager's profitability (and, by definition, any discount is itself a small portion of that small impact). But, this being a topic I actually know something about, I thought I could shed some light on the practice.
There are at least four reasons why it happens that a fund sponsor may pay less per hour for legal fees than its funds or their portfolio companies do.
First is the simple matter of "mix" of legal work. Regardless of whether a private equity firm is involved or a public company, not every hour of legal work by a given person is billed at the same hourly rate. Routine or compliance work tends to be discounted significantly. Brief, isolated inquiries may not get recorded or billed, because the lawyer or firm does not want to risk annoying the client with nickel-and-dime bills. Some routine work never gets billed, because the monthly amounts are too small, and by the time they rise to a level worthy of troubling the client, the oldest items are too stale; you just write them off as a goodwill gesture.
Conversely, large capital raises, financings and M&A often are billed at a premium to what a simple multiplication of hours worked times hourly rates would yield. Again, these disparities exist throughout the world of providing legal services to businesses, and are not unique to what Morgenson writes about. Since private equity funds and their portfolio companies interact with the fund sponsor's law firm predominantly on matters of financing and M&A, the legal bills they get from that firm will be higher than the ones the law firm may render to the sponsor on the sponsor's compliance matters. Should this be a concern? No, because even if the fund and the sponsor used separate counsel, the nature of the services each one receives is such that the same disparities would probably persist, as they do at public companies. Also - and this is important - because the portfolio company usually retains its pre-existing legal counsel for its routine day-to-day work, it gets similar discounts, just from other firms.
In large measure, this reminds me of the "equal pay for equal work" debate. If one merely takes the 50,000 foot view, and just sums all male compensation and all female compensation and divides them by the respective hours worked, one will get the often-cited statistic that women only earn 77% of what men earn. If one looks more closely at the "mix" of the work, and compares the amount paid for the exact same job, the disparity narrows considerably, to something more like 91%,if memory serves. You can spin it either way, but in intellectual matters generally, more respect is given to the more sophisticated and detailed understanding of datasets.
Ironically, Morgenson's own income probably reflects a similar variation based on "mix". She puts out a story / column every week for the Times, for which she is likely paid a fixed salary, or a flat amount for each one, regardless of page views, or citations, or retweets etc. But she also publishes books, and for those she is likely paid a royalty based on numbers of copies sold, which amount can vary considerably from the amount she collects for her newspaper work. Even though it's the same person doing the same task, and regardless of hours worked at either one, the conventions of payment in the two contexts lead to disparities in pay for "equal work".
Second, and somewhat related, is the fact that generally accepted accounting principles treat professional fees tied to financings and acquisitions differently from day-to-day legal fees. The latter are considered operating expenses that must be recognized currently, and thus reduce EBITDA and net income. In contrast, fees for work on completed financings and acquisitions are treated more like a capital expenditure and amortized over the life of the financing (or, in the case of many acquisitions, simply added to goodwill and never amortized a bit). Obviously these have different effects upon the client's enterprise value -- often expressed as a multiple of EBITDA -- and its stock price -- often expressed as a multiple of earnings per share. Thus, while a company's legal department often bargains hard for discounts on day-to-day legal work, when they do a large, one-time transaction, they are often much more accommodating of the fees of the firms involved, knowing that the market won't penalize them for any lack of discipline in that non-recurring context. So, to tie back to private equity deals, the funds and portfolio companies are, again, predominantly interacting with the fund sponsor's law firm on financings, capital raises and acquisitions so it stands to reason that they would pay that firm undiscounted amounts. Again, one shouldn't feel they are being screwed in some way -- they just get their discounts on routine legal services from different firms.
Third, there is the busted deal / completed deal disparity, which is another type of "mix" issue. It is a convention throughout investment banking, encompassing as well those who advise alongside investment bankers, that advisors on large deals eat some, or even all, of their fees if the deal doesn't close; but, conversely, when a deal does close, advisors will generally charge a premium above their hourly rates. The premium may or may not offset the discounts up to that point, because the premium may reflect other considerations such as the degree of extraordinary effort required to close the deal, or the relative contribution of a particular professional. A lawyer can do the exact same legal work in two instances, in exactly the same amount of time, using the exact same materials, and yet the revenue realized in respect of that work can vary by more than 100% depending on whether the deal closes or not. Since, by definition, portfolio companies held by a private equity fund are all closed deals, that fact will tend to bias their legal costs higher.
In point of fact, it was a common practice of the larger funds I did work with, and those I am invested in, that there was an end-of-year negotiation on how much would be paid in respect of unbilled time for work done during the year on the fund's behalf, and the sponsor would draw down on the LPs to fund the resulting payments. I don't recall a systematic practice of recovering par or implementing a particular discount. It was more ad hoc, driven, obviously, by how well the fund's investments were performing, just like any other business.
Last, there are the traditional billing factors of complexity, efficiency and certainty of revenue. A large PE deal necessarily the simultaneous coordination of at least half a dozen legal specialties and presents a host of complicated issues, some of which arise due to the laws regulating the tax-exempt investors in the acquiring fund. Closing one of those deals is not the same as the routine legal work on which discounts are customarily given. It's not unfair to charge more for harder work.
As well, as in any industry, clients who provide recurring revenue over multiple years are likely to be awarded discounts, while shorter-term relationships, such as a portfolio company whose work may move elsewhere in two or three years, do not build up such goodwill.
It's the nature of disclosure to err on the side of making things look as bad as they possibly could, as the issuer and its counsel know that they are only working on the disclosure because the market is likely to buy the security being issued, so there is no reason to downplay anything and risk getting sued later. By simply quoting those disclosures, some of which I assume my firm prepared, Morgenson thus is able to make this practice sound more nefarious than it really is. The underlying reasons are really quite generic to legal services, and unspecific to the private equity world. The only reason it comes up in the PE context is that the fund and the fund sponsor are different entities with different owners and everyone working for the fund wants to protect themselves against being accused of hiding something from the fund investors, so they disclose it in as unvarnished a way as possible.