- GPs reassess how various fees and expenses are allocated
- SEC scrutiny heightens importance of broken deal fee issue
- ‘Tourist’ co-investors push back
General partners are trying to shift more of the broken-deal-fee burden onto co-investors, many of whom aren’t used to paying these costs and are pushing back, according to three people with knowledge of the situation.
The trend in the market stems from GPs reassessing how to treat various fees and expenses, these people said. It also results from less experienced co-investors entering the market.
“What’s new is there are a lot of people who are not used to paying these fees. … I’m sure there’s a group of co-investors saying, ‘hell no, we’re not doing this,’” said one LP who is an experienced co-investor.
“If you’re a tourist co-investor, and you’re used to getting deals that are already closed and are being syndicated, this is new. It’s new to the tourists; it’s not new to people who have been co-investing for a long time.”
Funds have traditionally borne broken-deal fees because they represent the bulk of capital in the deals. Co-investors share in the fees, usually proportionate to their exposure to the deals.
This LP said that on deals they like, they will agree early — even when the GP has only made a bid in an auction — to pay their pro-rata share of the broken-deal fee. The LP said some organizations tout the fact that they pay broken-deal fees. “Some [organizations] make that a point of differentiation,” the LP said.
Committing to paying a broken-deal fee early requires risk but also signals confidence in the manager and the deal. The LP said they will commit to paying the fee only on those deals they feel are top quality. “We’re willing to take the risk and work with the sponsor and take our share of the expense,” the LP said.
Broken-deal risk can be allocated three ways: to the funds, to the managers or to co-investors, a fund-formation attorney said. Generally these expenses are shared between funds and co-investors.
In some cases, however, vehicles created for a manager’s own capital to be co-invested into deals have not been on the hook for broken-deal fees. The SEC settled with Kohlberg Kravis Roberts last year for $30 million, accusing the firm of excluding GP-affiliated co-investment vehicles from broken-deal fees without proper disclosure. In settling, KKR didn’t admit or deny wrongdoing.
The fund-formation attorney said some GPs, instead of shifting part of the broken-deal-fee burden to manager-affiliated vehicles, are trying to shift more of the cost to co-investors, including co-investors who aren’t used to paying these fees.
“GPs are trying to use the existence of the SEC to push broken-deal expenses on co-investors rather than [have] the manager bear the expense themselves. The manager looks and says, ‘if I can’t charge the fund, I have to charge someone other than … having to bear it myself.’
“Managers are not in the business of taking any risk. Anytime they see an impediment to them shifting risk to someone else, they try to find a way to shift it,” the fund formation attorney said.
This was disputed by two sources, who said managers are simply reviewing how they handle broken-deal fees and establishing best practices.
Co-investors are a diverse group these days, compared with years past, when GPs simply identified big investors who had the interest and ability to take part in a deal.
Co-investors might be LPs in the main fund, or third-party investors not committed to the flagship funds, or actual co-investment vehicles raised by the GP. They also are a much more defined group: For example, many LPs write their preferences for co-investing into side letters.
GPs are expected to disclose explicit co-investment allocation policies in limited-partner agreements. This is due to heightened SEC scrutiny of the industry, specifically focusing on ensuring certain LPs don’t benefit more than other LPs without that benefit properly disclosed to the full investor base, sources said.
The move toward spreading the broken-deal fee among co-investors is part of an overall reassessment by many GPs about how they treat fees and expenses, according to Amanda Persaud, partner in the private investment funds practice at Ropes & Gray.
“All these variables are going to inform the approach taken about who bears the broken-deal expense,” Persaud said.
How to allocate broken-deal expenses gained importance since the issue appears to be “top of mind” for the SEC, Persaud said, especially for those GPs who have not yet faced an SEC examination.
“My sense from seeing the co-investment issue over time is that folks are paying more attention to it because there’s generally scrutiny over fees and expenses, and broken- deal expenses is one category,” Persaud said.
Action Item: Check out the SEC’s KKR settlement here: https://www.sec.gov/news/pressrelease/2015-131.html
A guide (left) talks to a group of tourists at the cathedral in downtown Valencia, Spain, on July 23, 2015. Photo courtesy Reuters/Heino Kalis