Term Sheet

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Private equity's new fee trick

July 1, 2013: 11:44 AM ET

Balancing The Account By HandPrivate equity fund fees don't always cover what they are supposed to cover.

FORTUNE -- Almost all private equity funds charge their investors an annual management fee, which is used to cover such overhead as salaries, office space and administrative functions. It's usually around 2% on uncalled capital, and begins to ratchet down as the fund ages.

We can quibble on whether 2% is an appropriate percentage -- particularly when certain fund sizes become stratospheric -- but it's a fairly simple arrangement that both sides can easily understand before signing on the dotted line. Unfortunately, however, some private equity firms are beginning to violate the spirit of these agreements, by outsourcing certain activities and applying the charges on top of the baseline management fee.

Most limited partnership agreements allow for additional fees to be charged if the fund is required to hire outside help, such as in the case of a serious legal issue. But I'm hearing more and more about how some general partners are hiring others for tasks that should reasonably be expected to fall under the management fee, in order to juice the bottom line. Including due diligence, which is the main thing that general partners are hired to do!

Here is how one veteran private equity exec explained it to me:

"Moving services out of the management company to outside service providers is the new new thing. If you fire your accounting group and hire an outsourcer, magically the costs move out of the management company and to the investors. Ditto, due diligence. Ditto secretarial. Ditto annual meetings. Ditto marketing.

Good for everybody (but investors).  (Very) large consulting and service fees for the service providers (and "friends of the firm").  Particularly attractive tactic if you are a firm making most of your money off of fees rather than carry (because while it reduces ultimate return to investors, it is cash upfront to you)."

One place I've heard about some of this happening is inside of Credit Suisse's (CS) Customized Fund Management Group, which uses an outside firm called Copal Partners for certain functions. Got to wonder if that little accounting trick is one reason that the bank has had troubles selling the group.

Again, to be clear, I'm not alleging any breaches of contract. It's a violation of the spirit rather than of word. But that may change as limited partners begin to wake up to this shady practice, and begin to make future fund managers lay out exactly what management fees do and don't cover.

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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