March 19, 2007
By David Toll, peHUB

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 large 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 touchy 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.

According to Swaminathan, the earlier term sheet presented a laundry list of director fees and consulting fees. The proposed fees made the seller feel that the buyout professionals were more interested in redirecting cash flow into their wallets than investing in the business, he said. Virgo Capital got the deal a year later for three large reasons, Swaminathan believes: its expertise in business process outsourcing; its connections in the Midwest and Southwest where the company does business; and that it didn’t plan to take any fees, which signaled to the seller that the firm intended to have a true partnership.

Another virtue for the no-fee firms is that their investment professionals have no incentive to shut a deal other than the prospect of seeing their equity investment grow. It removes any temptation the professionals might have to do a deal at least in part to generate an upfront transaction fee. That limited partners applaud the resulting alignment of interests also comes in handy when it comes time to elevate additional pools of capital.

To be sure, LPs have made headway convincing buyout shops to share more of the transaction fees, monitoring fees and related fee income they generate. Where once general partners kept 100 percent of these fees, nowadays limited partners often get 50 percent or 80 percent through an offset to management fees.

Nevertheless, LPs say transaction fees remain a sore point. Why should buyout firms even keep half of, say, a 1 percent transaction fee simply for closing a transaction with LP money? One percent might not have been much money in the good old days – oh, say 24 months ago. But nowadays’s transaction fees would make Carl Icahn blush.

LPs might be ornerier if more of them knew how monitoring fees often worked. Buyout firms charge portfolio companies these fees for sitting on boards, and providing ongoing advice. According to one source, numerous portfolio companies agree upfront to pay these fees over a five to 10-year holding period. Should it get sold before then, the portfolio company actually pays a lump sum of unpaid monitoring fees as an exit fee – even if the buyout firm plans to have no more to do with the company.

What are the buyout firms monitoring after they’ve sold a company? Let me propose they keep tabs on the reaction of sellers and limited partners to growing fee income.