Fees Hit Private-Equity Cos.
Private-equity deal fees are standard business practice in the LBO world, but do they leave companies shortchanged?
By Kelly Holman August 21, 2009
Reader’s Digest Association Inc.’s pre-arranged bankruptcy plan to restructure $2.2 billion of finance obligations — debt largely incurred from its $2.8 billion acquisition by New York buyout group Ripplewood Holdings two years ago — is more than another household-name company’s attempt to survive. It’s an example of one way private-equity firms make money while at the same time sapping the corporate lifeblood of the companies they acquire: transaction and management fees.
Buyout firms levy these payments on the companies they acquire. They charge target companies a one-time transaction fee at the time of purchase to cover costs connected to debt-raising, due diligence and strategic planning activities. Furthermore, if a portfolio company subsequently acquires another company, it will often be charged an additional fee.
Then, after a business is acquired it generally must pay an ongoing monitoring fee to an affiliate entity of the private-equity acquirer for the financial and operational guidance that buyout executives provide to corporate managers.
The fees, simply put, are the cost of doing business with a buyout firm. In good times they may not be such a big deal, but in recessionary times when almost every bit of available capital is needed to buttress a business, pay employees and make interest payments, this process of remuneration looks suspect. Money that could be used to make debt payments and thus help keep a company solvent is instead being funneled back to financial buyers.
Reader’s Digest, for example, was recently on the verge of having to make a $27 million interest payment on $600 million of 9% notes. It announced a pre-arranged Chapter 11 plan on Monday through a deal with JPMorgan that lets it out of having to make the payment and give its senior secured lenders control of the business, which will wipe clean Ripplewood’s private-equity investment in the business. The plan, expected to be finalized with a Chapter 11 filing over the next 30 days, would pare Reader’s Digest’s debt load to $550 million.
When Ripplewood acquired the Pleasantville, N.Y., company in 2007, it was required to fork over $25 million as a transaction fee to the private-equity firm. It was also required to pay $7.5 million to Ripplewood and other financial firms through June 2008 after signing a “management services agreement” with the acquirer, according to Securities and Exchange Commission filings.
Ripplewood, of course, is hardly alone in extracting multiple streams of fee income from portfolio companies in the course of making investments. Convertible equity infusions on the part of private-equity groups can also result in the payment of transaction fees.
The $710 million equity investment that Boston’s Thomas H. Lee Partners and GS Capital, the New York private-equity unit of Goldman Sachs, sponsored for MoneyGram International in February 2008 is one example. MoneyGram paid a $61.9 million transaction fee.
Private-equity shops typically collect the fees through management company affiliates that are set up to receive the payments, rather than receiving the fee income at the general partnership level. The practice of including fees in leveraged buyouts has been employed by small, middle-market and large-tier private-equity firms for almost as long as the leveraged acquisition business has been around.
The fees arose in the early 1980s in order to help financial sponsors defray the costs of terminated deals and payments to target companies, explains Kevin Penn, managing partner of ACI Capital, a New York private-equity firm managing more than $500 million of assets. “Transaction fees were designed to cover the cost of broken-deal fees,” he says.
Considering that most LBO industry pioneers came from Wall Street institutions, like Henry Kravis and George Roberts, who left Bear Stearns to found Kohlberg Kravis Roberts in 1976, for example, it’s not surprising that buyout executives would seek to replicate a fee arrangement after their former employers. Investment banks, after all, charge their corporate clients fees when they arrange loans, raise capital or offer strategic advice.
The rationale for private-equity firms to charge fees may be clear enough, but not everyone thinks highly of the practice. One senior financial-sponsor banker at a New York bulge-bracket bank, who agreed to speak on the condition of anonymity, characterized the fees levied on portfolio companies as “outrageous” and comparable to the dividends paid to buyout firms through leveraged debt issuances in the 2005-to-2007 deal boom period. The fees are an additional source of income for buyout executives that are already compensated from annual fund management fees and carried-interest profits, the banker said.
Jeffrey Legath, a partner at Dechert LLP who counsels private-equity firms on transactions, disagrees. “These private-equity funds spend a large amount of time making companies better and helping them in all kinds of functions that other [minority] shareholders and board members can’t,” he says.
The fees, especially on transactions, can be substantial.
When Apollo Management and TPG acquired Harrah’s Entertainment in January 2008 for $30.7 billion, the Las Vegas casino operator was required to pay a $200 million transaction fee. Harrah’s was also required to meet an annual monitoring fee totaling $30 million, or 1% of the company’s annual cash flow.
As much as private-equity groups may be working with lenders to amend credit agreements of portfolio companies, the recession doesn’t appear to have mitigated the use of fee arrangements.
“There were still fees even on deals I’ve done in 2008 and 2009,” Legath says.
Meanwhile, private-equity managers also receive annual fund management fees amounting to 1.5% to 2% of capital committed to their limited partnership funds. It is capital that is paid to private-equity firms on the basis of covering salaries and overhead for buyout groups to finance their fund investment activities. These fees, however, have come under sharp scrutiny in the institutional investment community over the past year because investors have to shill out capital even though the buyout deal business has largely ground to a halt as a result of the credit crunch.
The hand dealt by market forces beyond the control of private-equity firms isn’t expected to change the pace of dealmaking anytime soon. With scant financing options, declining earnings and depressed purchase multiples, the transaction business is expected to be slow over the next few years. That means, in turn, that income derived from transaction fees has slowed. Thus, buyout groups will continue applying the fees despite the economic dislocation in order to fund their business activities.
Legath says some financial sponsors also employ prepaid oversight fee arrangements. In these cases a company will agree to pay an agreed-upon sum up front rather than pay an annual or quarterly monitoring amount. One advantage to the paying of an up-front fee is that it doesn’t get tangled up with a company’s credit facility, according to Legath.
Considering that management agreements can last for as long as 10 years or until a buyout firm exits an investment, paying a fee at the outset might be a less costly alternative for portfolio companies.
To posit the idea that transaction and management fees are driving companies into Chapter 11 would be flat wrong. But, there’s no question that during tough economic times they can chip into financial “value creation,” as buyout executives often like to call their business activity.
If Reader’s Digest winds up filing for Chapter 11, for example, it will join a list of other private-equity-backed businesses that have paid out millions of dollars in transaction and monitoring fees following a buyout.
The take from transaction fees is usually shared between a private-equity-affiliated management company and the firm’s institutional partners, though the percentage of the split can vary depending on the size of the fund manager. Large, multibillion-dollar partnerships may share as much as 70% of their deal and monitoring fee-related income with fund investors, compared with middle-market firms that may distribute 50% back to their limited partners.
An analysis last summer by Dechert on the fees charged in 60 leveraged acquisitions sponsored by 40 well-known private-equity firms illustrates how deal values influence the size of transaction fees. The study targeted deals that ranged from $155 million to $5.5 billion. The law firm found that when it came to transactions valued at more than $1 billion, the average fee totaled 1% of the buyout’s enterprise value. Smaller and mid-sized transactions commanded one-time deal charges of around 1.25%. In addition, the survey found that over the last six years transaction charges paid to buyout groups increased markedly, or by a mean annual $3.7 million compared with $1.42 million in 2003, the year Dechert released its last analysis on the fee issue.
By contrast, Dechert found that the management or monitoring fees charged post-acquisition generally didn’t change per deal size. On average, they amounted to $1 million to $3 million.
The lenders in a buyout, meanwhile, typically have a say as it concerns fees when portfolio companies come under financial stress. Credit agreements drawn up for leveraged acquisitions almost always have a provision that prevents financial sponsors from being paid a fee if a company defaults on its obligations.
“When portfolio companies get into financial trouble, they don’t need the additional burden of a sponsor’s monitoring fee. Dropping the fee is often just the right thing to do,” says ACI’s Penn.
The issue of management and transaction fees, though, is probably one of the things private-equity executives like Penn need to worry about least. While regulators have discussed raising taxes on private-equity profits, there hasn’t been much talk among legislators around reining in transaction and other fees that investment firms apply on their corporate holdings.
For now, it seems, they’ve finally caught a break on one front.
The following is a short list of some bankrupt companies and the fees paid to their financial sponsors in connection with their acquisitions as disclosed in SEC filings:
Aleris International Inc., a maker of rolled aluminum based in Beachwood, Ohio, was acquired by TPG for $3.3 billion in 2006 with $2.5 billion of debt. The business paid affiliates of the Fort Worth, Texas-based buyout shop $42.5 million in connection with the purchase. It also agreed to pony up $9 million annually for TPG’s management activities, an amount that would increase if TPG invested additional equity into the aluminum company.
In addition, Aleris’ management services agreement with the private-equity firm stipulated that the company pay TPG affiliates up to $36 million if the Ohio business launched additional capital-raising efforts through an initial public offering or carried out any other acquisition or financing transactions. Aleris’ business, though, went adrift over the last year as the recession took hold, prompting it to file for Chapter 11 earlier this year.
Linens 'n Things Inc., a retailer of house wares, was liquidated after filing for bankruptcy protection last year. The Clifton, N.J-based company paid a $15 million fee to affiliates of Apollo Management along with National Realty & Development Corp. and Silver Point Capital Fund Investments LLC for “financial advisory services” when it was bought for $1.3 billion in 2006 (30%, or $4.5 million, of the fee was accounted for in the purchase price) in a deal that left it highly leveraged, according to SEC documents. The company also paid an annual $2 million management fee to the sponsor group that ultimately lost $648 million after the company filed for bankruptcy.
Masonite, a Mississauga, Ontario, door maker that filed for bankruptcy in March 2009 to retire $1.9 billion of obligations, is familiar with paying deal fees.
The manufacturer paid a Kohlberg Kravis Roberts entity $30 million in transaction-related charges as part of its $2.7 billion purchase by the New York buyout firm in 2005, coupled with $2 million in annual management fees.
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