More Sun Capital Layoffs, More Questions

Two months ago, we reported that Sun Capital Partners had laid off just over 10% of its 200-person staff. My gut take was one of confusion. Shouldn’t a distressed investor like Sun be preparing for its salad days? Doesn’t Sun need an outsized staff, to execute on its strategy of intense, hands-on interaction with portfolio companies (operating execs in-house instead of by the phone, weekly reporting by portfolio cos., etc.)? And shouldn’t Sun have plenty of management fee income rolling through the door, given that it’s investing out of a $6 billion fund that is just 26% called down?

All of these questions came flooding back to me over the weekend, when I got word that Sun had laid off another 12 investment professionals. These new cuts follow Sun’s decision last month to close its Tokyo office (one deal in three years), and means that the firm has canned approximately one-third of its investment staff in 2009. Moreover, the firm has no plans to either reduce its fund size or reduce its fund management fees.

So I posed my questions directly to Sun, which emailed over the following statement:

“As part of our annual review process, Sun Capital made a modest reduction in our deal, operations, and support staff by eliminating certain positions in our Boca Raton and New York offices. Roughly half the positions were eliminated in our New York office following a change in leadership. We believe Sun Capital has an excellent team to lead us into the future. We also believe this economic environment offers an excellent opportunity — perhaps the best buying environment since 1980, and the opportunity to achieve historic returns for our investors.”

While I was pleasantly surprised to receive a response outside of normal business hours, the statement itself offered little more than confirmation of the layoffs (which Sun doesn’t even characterize as such). But some current and former Sun employees were a bit more helpful, as were a couple of its limited partners. Specifically, they offered an alternate explanation for why Sun might be cutting headcount so drastically. The details of what I’m about to describe have been confirmed by multiple sources. The conclusion is mostly mine.

Like most every private equity firm, Sun Capital Partners charges its LPs an annual management fee on its funds. This works out to hundreds of million of dollars over the first few years of a $6 billion fund’s life.

Unlike most private equity firms, however, Sun does not use that money to pay staff salaries, bonuses, travel expenses or office expenses. Instead, the majority of that capital is used for the general partner contribution to Sun’s fund, on behalf of Sun’s co-CEOs and a group of other senior managers. To “keep the lights on,” Sun mostly relies on transaction fees and portfolio company monitoring fees.

Why would Sun structure itself this way? The basic answer is that it’s a tax play. By pushing management fees back into the fund as GP contributions, the senior managers can avoid paying taxes on that capital as ordinary income. Instead, they hope for carried interest – on which they’d pay at a 15% rate (at least for now).

Sun is not alone in employing this bifurcated system, and it works fine. Well, it works fine so long as transaction and portfolio management fees keep flowing. If they dry up, then who pays to keep the lights on?

That is arguably the situation Sun now finds itself in. Portfolio monitoring fees are still coming in, but new transactions (new deals, add-ons, liquidity events, etc.) are less common than flights leaving LaGuardia this morning. Less cash coming in means less cash available to go out… which means fewer mouths to feed.

To reiterate, Sun declined to comment on anything related to its fund management structure. And I’m almost certain it would argue that my analysis is off-base. But the reality is that private equity firms with billions in dry powder should have little cause to engage in mass layoffs – unless they couple such moves with fund size or management fee size reductions.

Sun, however, is requiring its investors to pay as much today as it was requiring them to pay last December, even though Sun’s personnel expenses have dropped substantially. That math just does not add up.

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13 Comments

  • You finally nailed it on the Sun situation, but didn’t mention one thing. Sun is in a situation not only when new deal fees aren’t coming in like they used to combined with fewer portfolio monitoring fees. There are less portfolio fees because Sun is in default on so many of its credit agreements and is not able to collect. I specifically know of one other PE group that is facing a similar situation and wouldn’t at all be surprised if there are many others out there that recently grew investment and operating staff substantially and are trying to figure out how to pay for them as defaults rise throughout 2009. Aside from pricing and fees, lenders are becoming increasingly vigilant on reevaluating portfolio monitoring fees.

  • “The basic answer is that it’s a tax play. By pushing management fees back into the fund as GP contributions, the senior managers can avoid paying taxes on that capital as ordinary income. Instead, they hope for carried interest – on which they’d pay at a 15% rate (at least for now).”

    I’d be interested to hear what a tax accountant has to say, but as far as I know, it’s pretty difficult to avoid paying personal income and payroll tax on surplus (i.e. all expenses before GPs) management fees. Some firms do have the management company lend money to the GPs to make their calls, but this only works to the extent that the firm has enough non-cash losses to offset the cash loaned for the calls,otherwise the management company (either LLC or Inc) still has income that ends up as personal income to the GPs one way or another.

    The more likely scenario is that the management company is simply making the capital calls then tax grossing them up for the GPs. This means that every time a capital call is made the management company makes them on behalf of the GP and then also pays the income and payroll taxes associated with them. The goal of this is not avoid ordinary income taxes but simply for the GPs to avoid having to write a check with the nice side benefit of paying themselves even more money. One side benefit is that they can also say to their LPs with a straight face “our GP salaries are only $X”, but the reality is that they are 3X when you count the calls.

    As to you main point of burning up all the management fees on capital calls, this really depends on A) what fees you charge B) what the GP’s % capital commitment is C) how fast you call the money. In a fund with a 2% committed capital fee and a 1% GP capital commitment, it’s very hard to burn up all the fees on capital calls unless you call all the capital in the first year. However if the GP makes a much bigger capital commitment, say 5-10%, and draws lower fees (say 1% AUM) then it would be very easy for them to burn up their fees making calls in some if not all years.

    On a philosophical level, making capital calls out of management fees does defeat the purpose of a GP capital commitment, however unless the LPs put some kind of restrictions on GP management compensation, it’s really six, 1/2 dozen or the other, as the GPs will just write a check to the fund right after getting their paycheck.

    If LPs really want GP skin the game they should require that GPs put at least 10-20% of their net worth’s into the fund upfront in cash. That’s real skin in the game. Requiring 1% of AUM while paying them 2X that (per year!!!) really just incents people to pay the calls out of fees, so you end up with GPs that are just playing with the house’s money and doing stupid things like what you describe in your article.

  • I am an individual investor in Sun and I’d like to add some color as a very disappointed former fan of the founders. See below. It’s greed, greed, greed at its worst. They did not have to do this. This was avoidable but for the greed of the founders.

    ————

    Two months ago, we reported that Sun Capital Partners had laid off just over 10% of its 200-person staff. My gut take was one of confusion. Shouldn’t a distressed investor like Sun be preparing for its salad days? Doesn’t Sun need an outsized staff, to execute on its strategy of intense, hands-on interaction with portfolio companies (operating execs in-house instead of by the phone, weekly reporting by portfolio cos., etc.)? And shouldn’t Sun have plenty of management fee income rolling through the door, given that it’s investing out of a $6 billion fund that is just 26% called down?

    All of these questions came flooding back to me over the weekend, when I got word that Sun had laid off another 12 investment professionals. These new cuts follow Sun’s decision last month to close its Tokyo office (one deal in three years), and means that the firm has canned approximately one-third of its investment staff in 2009. Moreover, the firm has no plans to either reduce its fund size or reduce its fund management fees. The worst part of this is that they are laying off their best guys, the guys who have opinions and speak up, and keeping the “sheep”, mostly in Boca where job prospects are bleak and the staff is known for being second tier. The founders don’t want anyone around that aren’t completely helpless and without prospects for alternative employment. I know because in the investment process I met their team. Who has a $6 billion fund with most of their investment professionals in godforsaken Boca? Only Sun Capital. Even HIG, their smaller competitor in Florida, is setting up a NY office – now – because they can’t attract good enough people to live down south. Go figure.

    So I posed my questions directly to Sun, which emailed over the following statement:

    “As part of our annual review process, Sun Capital made a modest reduction in our deal, operations, and support staff by eliminating certain positions in our Boca Raton and New York offices. Roughly half the positions were eliminated in our New York office following a change in leadership. We believe Sun Capital has an excellent team to lead us into the future. We also believe this economic environment offers an excellent opportunity — perhaps the best buying environment since 1980, and the opportunity to achieve historic returns for our investors.” Right, so they cut their investment staff by close to half! They are in deep shit. The funds are doing terribly and they overinvested some funds and have limited liquidity to support their companies. They have had to go to the Advisory Board, people I know, to ask for approval to support companies in some funds with their new fund. This has all the LPs up in arms. They have made a mess of it. They may have trouble getting LPs to make their capital calls…Beginning of the end?

    While I was pleasantly surprised to receive a response outside of normal business hours, the statement itself offered little more than confirmation of the layoffs (which Sun doesn’t even characterize as such). But some current and former Sun employees were a bit more helpful, as were a couple of its limited partners. Specifically, they offered an alternate explanation for why Sun might be cutting headcount so drastically. The details of what I’m about to describe have been confirmed by multiple sources. The conclusion is mostly mine.

    Like most every private equity firm, Sun Capital Partners charges its LPs an annual management fee on its funds. This works out to hundreds of million of dollars over the first few years of a $6 billion fund’s life.

    Unlike most private equity firms, however, Sun does not use that money to pay staff salaries, bonuses, travel expenses or office expenses. Instead, the majority of that capital is used for the general partner contribution to Sun’s fund, on behalf of Sun’s co-CEOs and a group of other senior managers. To “keep the lights on,” Sun mostly relies on transaction fees and portfolio company monitoring fees. All the investors now see what happened. These idiots obviously grew the firm and budgeted, if they did any budgeting, for doing 30-40 deals a year and normal exit activity. Now they don’t have the cushion of the annual management fee to make up for lower deal fess and portfolio management fees. The guy who should be canned is the CFO of this disaster of a firm. This model – a trunaround model – requires a lot of people and a lot of talent. They are gutting their own model. Call them on it.

    Why would Sun structure itself this way? The basic answer is that it’s a tax play. By pushing management fees back into the fund as GP contributions, the senior managers can avoid paying taxes on that capital as ordinary income. Instead, they hope for carried interest – on which they’d pay at a 15% rate (at least for now). Exactly – they are taking advantage of the tax code loophole – but did not share this with their employees until recently when they ran out of cash. See below.

    Sun is not alone in employing this bifurcated system, and it works fine. Well, it works fine so long as transaction and portfolio management fees keep flowing. If they dry up, then who pays to keep the lights on?

    That is arguably the situation Sun now finds itself in. Portfolio monitoring fees are still coming in, but new transactions (new deals, add-ons, liquidity events, etc.) are less common than flights leaving LaGuardia this morning. Less cash coming in means less cash available to go out… which means fewer mouths to feed. This is exactly right. They call it “fee roll” – a one time election they can’t take back without disastrous consequences to the founders – unless they come to investors and try to restructure which we are unlikely to allow. But to make it worse, when they raised Fund V, the founders paid themselves the first year’s management fee of $120mm – $60mm smackers each (ask LPs – it’s in the docs); the employees know this. Rodger Krouse bought a huge Park Avenue apartment and renovated it to the nines and Marc Leder bought a huge house in Vermont. Meanwhile, I have heard from the younger guys there that Sun employees were always paid below the market and the founders used the argument that you won’t be paid at the top but you’ll be more stable and have job security. I remember that a lot of LPs, myself included, were upset that they wouldn’t disclose comp or carry of their top people in the last fund raise – now we know why. Well, guess what? This year they are paying NO CASH BONUSES – zero – after taking $120mm out of the firm last year and burying their fees in the fund for tax advantages – fees that they have not shared with anyone until now that they have no cash – they are paying “fee roll” this year to all but the catch is it takes a year to vest. Ask the departing employees about how they have been screwed by the vesting schedule. The problem is that the interests of the founders are not alligned with employees or LPs. They can lose half their capital and still be rich. They no longer care. This is likely the end. The model was not broken. They broke it…or made it go broke.

    Now comes the juicy part. Marc Leder is getting divorced and losing half his wealth. It is clear to everyone that he made a grab back of unvested carry and the bonuses of higher paid employees to make some of that back. He has to make a cash payment so he retains his 50% ownership of the GP. This is shameless greed, Madoff II. And like Madoff, it’s coming out of the pockets of mostly Jewish employees who believed the hubris and the bit about stable income and job security.

    To reiterate, Sun declined to comment on anything related to its fund management structure. And I’m almost certain it would argue that my analysis is off-base. But the reality is that private equity firms with billions in dry powder should have little cause to engage in mass layoffs – unless they couple such moves with fund size or management fee size reductions.

    Sun, however, is requiring its investors to pay as much today as it was requiring them to pay last December, even though Sun’s personnel expenses have dropped substantially. That math just does not add up. Nope!

  • Any way to get the names of the people like last time? Interesting way they structure things…

  • William,

    I’m trying to, but it’s been difficult so far. Last time I found a cached version of Sun’s “team” page from its website, but that seems to be gone. If I get them — or if someone sends them over — I’ll be sure to let you know.

  • One additional factor is that the financial performance of the “invested” management fees has probably been weak, so in addition to cash flow issues, the management fees to the owners is not worth what they expected, so they may feel relatively “poor” getting the benefit of only a portion of the deferred fees.

  • Bill Burnham – this is a straightforward management fee waiver program. At the inception of the fund or before the start of a particular year, the GP waives its management fee in advance. Instead of receiving a management fee, the amount is invested in portfolio companies on the GP’s behalf (with funds provided by the LPs). When the portfolio companies are liquidated at a profit, the GP has a priority interest in the amount of profits equivalent to the management fees invested in that deal. It’s not the same as carried interest…it is a profits interest. The reason it works for tax purposes is that if the total portfolio does not generate a profit, then the GP doesn’t get any of the waived management fees. Same if the fund doesn’t invest all its remaining capital…if the GP has waived too much, and the fund ends up with dry powder at the end of the fund, then the GP is out of luck. The risk of loss with respect to the waived management fees is the quid pro quo that makes it work for tax purposes.

    Again, this is a garden-variety feature in many private equity and VC funds.

  • To add to the above…it is a garden variety feature in many funds, but not to the $$ extent used here…Sun obviously was using this structure far beyond most. The waiver usually is a smaller portion of the fee, and the waiver is a non-event to LPs who are paying the money anyway….whether as directly to the GP as a management fee, or as a capital contribution to the fund as a profits interest to the GP.

  • Jesus! What a train wreck for the industry.

    The greed in the financial sector is finally being exposed. Unfortunately, at the expense of pension holders etc.
    There has to be more transparency in the money management business. These secretive Hedge Funds, PE and VC firms have been the accelerant to the burning fuse that has turned the economy upside down. After spending 8 years in the industry I had to get out after a pe firm took a company private and then paid out a *special dividend* for the benefit of only the Partners of the pe firm. In short, use investor money to pay a premium for a company, take it private and then pay out from the companies balance sheet hundreds of millions in a *special dividend*. This is criminal. I almost forgot. Not only did the pe firm take a few hundred million, but they decided to streamline the business by laying off 25% to 30% of employees.
    I think eventually the company had to reorganize (Chapter 11).

  • The Internet has been a great technological breakthrough, no doubt. In fact, the likes of Bill Gates and Tom Friedman have elaborated in their best-selling books on how the Internet has greatly democratized the acces to and dissemination of information. With this happening, though, each individual who decides to engage in the popular practice of “blogging” must accept a sense of journalistic responsibility which before was only necessary for real journalists to embrace and/or abide by.

    That being said, I strongly believe that to avail oneself of this powerful medium for making negative or disparaging remarks about anyone, should be burdened with a minimum sense of ethical responsibility, let alone when comments are being pointed at highly reputable professionals like Rodger Krouse and Marc Leder, who happen to have built one of the best private equity franchises I am aware of. I would offer a plausible [albeit more boring but certainly commonsensical], alternative rationale behing the staff reduction saga. Could it be that with deal flow significantly down these days, they found themselves with too much excess capacity within the management company to ignore it, and instead opted to use the same yardstick of fiscal discipline that they impose on their portfolio companies? I understand they have managed to shave close to a billion dollars of operating costs out of the existing portfolio….just an alternate view, for what it’s worth.

  • Confirmed. Everything Curious George says is what a friend of mine who works at Sun Capital has reiterated, because he has been underpaid for years, and received no bonus this year.

  • Kevin and Raul are probably other PE guys or cronies of the founders of Sun who sympathizes with these crooks — maybe doing the same “garden variety” greed. To grow a firm and fund it with deal flow, you idiots, is in direct contradiction to investor’s interests. This creates an artificial bias towards doing a large number of deals and not doing only good deals. This is contrary to the mission statement they so proudly touted last fund raise…I should have known when I heard them bragging about number of deals and no longer quality of deals. The fees they refused to share their partners should pick up the slack when deals get hard to do or exits are tough to do – their only source of cash flow now that they greedily took it away. Hence zero cash bonuses and fee roll to even the most junior guys who now are struggling to make their mortgage payments…Rolling $120mm of fees a year was nothing short of irresponsible. Unfortunately, investors didn’t get this when they committed to the last fund. They probably thought, wow, what a commitment! Well, this turnaround model needs a lot of people and really good people who are committed. Who would stay? No cash comp, carry likely sucks now (and they apparently were niggardly with carry saying that it was “worth more” – ha!). As someone else said above, nobody rolls this much and nobody hordes the fees. The model is broken and, what’s worse, by their own hands…in the cookie jar. These are just bad guys. Call a spade a spade.

  • Dan send me PM, I can help you find the names of the missing ones.

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