In Praise Of The No-Fee Approach

Deal fees, monitoring fees and exit fees have become big business for buyout firms. Case in point: The Blackstone Group recently paid itself a $200 million deal fee for the $39 billion buyout of Equity Office Properties Trust, keeping half for itself per its deal with limited partners.

Surprisingly, a handful of buyout firms decline to charge such fees, although they’re hardly motivated by a desire for martyrdom. Veteran firms Hellman & Friedman LLC, San Francisco, and Warburg Pincus LLC, New York, along with start-up Virgo Capital, with offices in Oklahoma City, Okla., and Austin, Texas, either don’t charge their portfolio companies fees or, in the case of H&F and Warburg Pincus, do so only when participating in club deals (in which case they either give 100 percent to their limited partners or use the fees to buy additional equity).

Being feetotalers perhaps puts these shops at a disadvantage in the hunt for talent, since rivals can pad their payrolls with the additional fee income. But sources at these firms point to two big advantages to their approach. Both could lead to handsomer returns over the long run.

For one thing, not charging portfolio fees can give these firms an edge when facing rival bidders. Potential sellers have grown far more sensitive to whether buyout firms seem intent on investing in the growth of a company, or taking cash out at every turn. It’s particularly true for sellers who roll over equity. Why should their fellow shareholders—the buyout firm professionals—absorb a payout from transaction fees and monitoring fees when they themselves aren’t accorded the same privilege? Aren’t doing deals and keeping tabs on portfolio companies what they’re supposed to do as active investors? It’s also hard for buyout firms to promote pay-for-performance to managers if they’re ostensibly not willing to play by the same rules.

Make no mistake, no one at the no-fee firms would claim to have won a deal simply because they don’t charge portfolio company fees. But they do argue persuasively that not doing so makes a difference. Guhan Swaminathan, a co-founder and managing director of Virgo Capital, recently signed a letter of intent to buy a business-process-outsourcing company that a year earlier had rejected an offer by another buyout shop.