LPs miss opportunity to fight back on fees

New Jersey State Investment Council Chairman Tom Byrne asked a simple, important question at the council’s Jan. 25 meeting.

The state’s Division of Investment had just informed the council that TSG Consumer Partners would be increasing the annual management fee on two investment funds that held final closes in 2015, a move that could cost New Jersey pensioners as much as $100,000 per year in additional fees.

The spike in management fees required majority approval of TSG 7A and 7B fund investors. Under the amended fund terms, TSG would also be barred from collecting investment-banking fees that had previously been used to partly offset LP management fees. New Jersey voted against the amended terms, staff told Byrne.

“Why would other LPs approve this?” Byrne asked.

Great question — but there doesn’t appear to be a great answer.

The amendment’s ultimate impact is tough to discern, as it’s unclear how much or how often TSG would have charged its portfolio companies investment-banking fees. Why TSG requested the change to its terms also is unclear.

What is clear: TSG gave LPs a choice to pay a higher fee or a lower fee. A majority of LPs opted for the former.

LPs and GPs frequently use pendulums as a metaphor for fund negotiations. When returns are down, and demand is weak, the pendulum swings in the LPs’ favor. When investors are chasing yield and fund managers are raising oversubscribed funds, the pendulum swings to the GP.

In today’s market, the pendulum favors the GP, and managers like TSG hold particular sway. TSG 7A and 7B, the funds whose terms were changed, attracted more than $6 billion of investor demand before holding a final close on a combined $2.5 billion, a 2015 news release says.

Some, if not all, of that demand can be attributed to TSG’s track record. At the time of the vehicles’ final close, the 30-year-old firm’s average fund IRR was about 24 percent, the news release says. A Colorado pension pegged TSG’s $1.3 billion 2012 flagship as netting a 45.9 percent internal rate of return through Dec. 31, 2015.

At the meeting, New Jersey Portfolio Manager Meghna Desai hinted that TSG’s history of high returns and oversubscribed funds may have prompted some LPs to approve the amendment with TSG’s next fundraise in mind.

“They’ve performed really well and always been over-allocated, so some LPs may view it as a way to keep [their allocation going] into the next fund,” she told the council.

OK, sure. But the firm doesn’t appear to be raising a fund anytime soon — New Jersey’s commitments to TSG 7A and 7B are less than 20 percent deployed, according to its most recent investment report. Why yield ground in the battle for future fund terms when it’s not imperative to do so?

LPs rarely have this sort of leverage over a fund manager with TSG’s return profile. Even with TSG’s long, exemplary track record, LPs missed an opportunity to cut costs and keep fund terms in line with market norms.

Action Item: For more information about New Jersey, visit  www.nj.gov/treasury/doinvest/

Tully Friedman (left), managing partner of FFL Partners, speaks with Sam Sutton of Buyouts at the LP-GP Summit on Sept. 19, 2014. Photo by Robert Paul