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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