The $40 Billion Of Debt Hidden In Buyout Funds

Would you be surprised to learn that buyout funds have over $40 billion hidden in off–balance sheet debt? Limited partners often think of hedge funds as the only asset class with hidden liabilities. But if you have invested in a private equity fund you have assumed a significant obligation—over ten years of relatively fixed management fees.

Management fees for private equity funds closely resemble debt for a number of reasons. First, in most cases, management fees are fixed for the investment period and become somewhat variable during the harvest phase. This is in contrast to many other investment vehicles where the management fee is tied to the value of assets under management. For example, if a hedge fund declines by 50 percent, its management fees will also decline by half.

Second, management fees are generally cancelable only in very rare cases such as the departure of key individuals or fraudulent activity committed by the manager. Even when a key-man event is triggered, many limited partnership agreements only allow for the termination of the investment period while the management fees continue to get paid.

Finally, there is no easy way for investors to rid themselves of this obligation. Investors in mutual funds can choose to opt out of future management fees by simply redeeming their interest. Limited partners in private equity funds can sell their investments to a secondary fund, such as those managed by my firm, VCFA Group. While this frees the seller of future obligations, in most cases investors sell at a discount, taking a loss in order to be freed of their commitments. In fact, in some extreme circumstances, we have had investors pay us to assume their future fee obligations.

The accompanying chart estimates the undiscounted remaining value of private equity management fee obligations for U.S. buyout funds as of December 31, 2011. It shows that vintage 2011 funds had remaining estimated management fee obligations of almost $9 billion, or over 10 percent of the $71.8 billion committed that year. Strikingly, funds raised in 2007 still had remaining obligations of nearly $11 billion four years after their inception. To estimate the debt obligation, I assumed five years of management fees at 2 percent of commitments per annum during the investment period. I then assumed a harvest period of five years with fees beginning at 1 percent per annum and declining by 10 percent per year. Even if you make more conservative assumptions (e.g., reduce the management fee to 1 percent) it is difficult to estimate much less than $30 billion in hidden debt.

These calculations are important for any investor with an aging private equity portfolio. In older funds management fees can eat away at the remaining value of a fund. For example, we considered purchasing an interest in a 2001 vintage fund almost ten years after its inception. The management fees amounted to over 5 percent of the current value of the fund’s assets. The seller was unaware of this hidden liability and was surprised that our offer price incorporated future management fees. Even if a fund’s management fee is calculated as a percentage of the remaining asset value, the limited partner is relying on the manager to provide accurate and conservative valuations when their financial incentive is quite the opposite.

Countless endowments, foundations and pension plans have benefited from their investments in private equity. Yet few other asset classes carry the type of obligation created by private equity management fees. Moreover, limited partners may not recognize the importance of these fees at the outset. Before investing, limited partners should carefully negotiate management fees to ensure that their interests remain aligned with the fund manager’s for years to come.

(David Tom, CFA, is a Managing Director with VCFA Group, which is managing a $250 million buyout secondaries fund and a $250 million venture secondaries fund. Reach him at dtom@vcfa.com.)

This column first appeared on the Web site of sister magazine Buyouts.

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