Don't Get Gouged by Private Equity Fees Odds are, your banker is looking to make money, not a fair deal. Here's how you can manage your relationship with a private equity firm.
Opinions expressed by Entrepreneur contributors are their own.
I make my living in private equity. If you're an entrepreneur or investor and you're in the dark about how PE fees work, you could end up rewarding PE guys whether they perform for you or not. As an entrepreneur looking for capital, you might say (and think), "My banker has my back." Maybe your banker does. But, bankers can be like real estate agents -- getting a deal done (not necessarily the best one for you) is job one.
Related: How to Decide Whether You Need Debt or Equity Financing for Your Business
Here's how entrepreneurs and investors can fire back and get a fair deal.
Pull back the curtain.
PE firms love calling the shots -- setting the terms for entrepreneurs who need capital and tantalizing investors with outsized returns. When everyone is winning -- meaning portfolio companies are soaring and the fund is beating bets -- entrepreneurs and investors don't think about fees. But, in the last two years, the race for quality deals got supercharged along with the multiples PE firms pay for acquisitions. I now see deals at 15 times EBITDA -- almost double the old industry standard. At that multiple, it's nearly impossible to deliver the growth rates investors expect. So, the PE guys produce value by charging fees for company operations instead of funding growth.
What fees? If the PE firm recapitalizes your balance sheet, you pay a fee. Making an acquisition? There's a charge for that. Are you tapping the PE firm for advice to help your business grow? That triggers a monitoring fee. It's a deplorable strategy.
Entrepreneurs have to run the numbers and know how to read the PE dealmakers. In advising entrepreneurs what to ask for, I interviewed Timothy Kelly, a private equity specialist who retired in 2013 as a senior partner with Adams Street Partners. Kelly says, "First, absolute full disclosure of any and all fees charged is a must. It's the only way to determine whether they are fair relative to the returns."
Related: Why Family-Business Entrepreneurs Should Embrace Private Equity Funding
According to Kelly, some PE firm fees are justified, but getting full disclosure is a way to make the assessment. To put the full-court press on fees, take these steps:
1. Make bankers compete for your business: To find a banker who's on your side, pick three banks via an open process. Bankers should want to compete; if they don't, ditch them. Gauge a bank on the quality of its materials and advice. Do they peddle improbable hockey-stick projections? Do they know your industry well enough to understand what motivates partners, customers and suppliers?
2. Talk debt: If the PE firm takes a majority position and controls your board, the firm can leverage up the company and take a dividend. It's a common maneuver. The entrepreneur's best defense is to retain rights over how much debt the PE firm takes on to limit excess debt.
3. Know real risk: When a PE firm takes a "participating preferred" equity stake, it favors the PE firm because dividends are taken out. To counter, entrepreneurs can push for a "convertible preferred" stake; this serves up a return on the cost of capital, but if convertible preferred shareholders convert their holdings to common stock, then the entrepreneur's obligation to pay a dividend ends. PE pros will say they're taking the greater risk and have to recover their cost of capital. The entrepreneur's best comeback is: "I'm taking the risk that our incentives as partners are synched."
4. Pin down compensation: Ask PE firms how they compensate their general partners. It's a question that'll command respect. Also ask them if they base financial incentives on delivering growth (carried interest) or revenue (fees).
5. Beware of multiples: Anything over 10 times EBITDA challenges growth rates, which limits investment capital. Kelly's advice: "Getting a higher multiple isn't the end-all because fees might reduce overall what's being paid."
6. Dig into the PE budget: Ask for insight into the PE firm's operating budget to determine if the fees they're charging just cover operating expenses or create a profit center. If it's the latter, or if the PE firm stonewalls you, there's likely an issue.
Related: The Do's and Don'ts of Private Equity for Entrepreneurs
Make fees transparent.
Illinois State Treasurer Michael Frerichs told me in an interview that transparency with fees and expenses is a must-have and more competition among PE firms would make things fairer.
"Transparency should be the standard," Frerichs says. "Fees should be competitive, decrease through the investment and conclude at the end of the investment."
Frerichs says his office will pass on PE fund investments unless the PE firm uses something like the Institutional Limited Partners Association (ILPA) template for reporting fees and adding up returns based on the performance of the entire fund (instead of deal by deal). Frerichs adds, "If PE firms believe in their value and the free market, they shouldn't be scared of competition. If they're really delivering value, they should succeed."