Secret Fees and Stolen Code

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
Read More.
a | A

Secret fees.

Here is a story of secret private-equity fees:

While top-line fees associated with these funds are well known — management typically charges investors 1 to 2 percent of assets and about 20 percent of portfolio gains — many charges are hidden from view. These include transaction fees, legal costs, taxes, monitoring or oversight fees, and other expenses charged to the portfolio companies held in a fund.

Here's the report on which the story is based, by CEM Benchmarking, which argues that "the time has come for standardized total cost disclosure for private equity." The problem is that private equity firms usually charge monitoring, advisory, etc., fees to portfolio companies, and then rebate most of those fees against the disclosed management fees that they charge limited partners. Then they bill the limited partners for the management fee net of the rebates. So in CEM's example, the management fee is 165 basis points, the portfolio company fees are 50 basis points, and 80 percent of those fees are credited to the limited partners. The "typically reported management fees" would be the net 125 basis points (165 - 50 x 0.8). But the "actual costs incurred by LP" would be 175 basis points (165 - 40 + 50), because the portfolio companies pay the full 50 basis points to someone, reducing the limited partners' return.

Now two points here. One is that there is no meaningful sense in which those fees are secret. The partnership agreements disclose the management fees, the existence of monitoring fees, the rebate structure, etc. In the example above, you can convert from the "typically reported" fees to the "actual costs" easily, just by knowing the stated management fee, the reported net fee, and the GP/LP split of the monitoring fees. Obviously the private equity firms like to report lower headline fees, and their critics like to report higher total fees, but the actual amount of fees is available to everyone. (I mean, to the limited partners anyway.) It's a question of framing and accounting, not of secrecy.

The second point is: What is the right answer? CEM assumes that all costs charged by private equity firms to their portfolio companies should be treated as fees charged to limited partners. But if you invest in public equities through an index fund, the only fees that the index fund charges you are for the fund's investing, administrative, etc. expenses. All of the expenses involved in managing the "portfolio companies" -- the public companies in the index -- are of course expenses of the companies, not the fund; the fund is cheap. But some of the expenses of managing private equity portfolio companies show up -- or might show up, or arguably show up -- as expenses related to the private equity firm, which after all manages those companies. So board costs and "transaction fees" and "legal costs" are to some extent expenses that the company would have paid anyway, but that it happens to be paying to the private equity managers rather than third parties. Perhaps the private equity firms overcharge, but I'm not sure that classifying 100 percent of those expenses as private equity fees is the right way to make an apples-to-apples comparison.

An annual meeting.

Berkshire Hathaway had its annual jamboree this weekend and you could "buy running shoes, rubber ducks, ketchup bottles and even boxer shorts bearing the image of the Oracle of Omaha." Doesn't that sound sort of terrible? Apparently the meeting went through 17,500 pounds of See's Candies. Myles Udland went to Buffett's favorite steakhouse and I don't want to alarm you but it really looks like the hash browns are topped with slices of American cheese. A jarring note in the folksiness came when a reporter who has written critically about Berkshire Hathaway's Clayton Homes mobile-home business approached Warren Buffett, and "Buffett immediately replied by asking if he and the other reporter on the Clayton story were 'roommates.' The reporters have never been roommates." 

Here is DealBook's play-by-play of the meeting, and the Wall Street Journal's. Besides Clayton, Buffett came in for some criticism over Berkshire's 3G Capital ties, and was skeptical about raising the minimum wage. Here are some takeaways. Here is Buffett's philosophy, and "What You Should — and Shouldn’t — Learn from Warren Buffett". Here is a narrative of all the stuff you're probably buying from Berkshire. Disclosure: I bought car insurance from Geico this weekend, in lieu of writing about the Berkshire annual meeting. 

Poor Sergey Aleynikov!

After a long trial and a week-long sketch comedy routine of jury deliberations, he was convicted again of stealing code from Goldman Sachs. Aleynikov is by all accounts a brilliant computer programmer, and you could forgive him for perhaps thinking that the jury that convicted him was not quite jury of his peers:

Earlier, the jurors showed their confusion by repeatedly seeking clarification from the judge.

On April 24, along with having the charges read out loud multiple times, including once when they directed the judge to read “slowly,” they also requested definitions of “tangible” and “major economic benefit.”

They also did this:

The prospect of a mistrial stemmed from a dispute between two jurors deciding Mr. Aleynikov’s fate, with a female juror accusing a male one of “food tampering” — in part because an avocado was missing from her sandwich. The female juror also said she had taken a blood test to determine whether she was poisoned, turning the criminal proceedings into a culinary whodunit.

I am generally a big believer in the jury system but one gets the sense that this jury did not do its job with the seriousness and intelligence that our Founding Fathers expected. The judge is going to think it over for "the next five to six weeks" and then decide whether to throw out the jury's verdict; even if he doesn't, you'd hope he'd at least sentence Aleynikov to time served so we can all forget about this years-long pointless infliction of misery.

An agency problem.

Here is a delightful discussion paper from the Federal Reserve about "An agency problem in the MBS market and the solicited refinancing channel of large-scale asset purchases." The agency problem is that, once a bank has sold residential mortgage-backed securities to the Fed, the bank is more likely to try to get borrowers to refinance those mortgages, because the Fed rather than the bank now bears the prepayment risk. A classic agency problem: The actor with the ability to refinance the mortgage (the bank) is no longer the actor who bears the cost of that refinancing (the Fed), so the bank acts in a way that is inefficient for the Fed. Except that that's what the Fed wants, in its capacity not as MBS investor but as central bank:

This agency problem—a key feature of the MBS market—arises when originators of mortgages that underlie the MBS no longer share in the prepayment risk of the securities, thereby increasing incentives to solicit refinancing activity. Therefore, Federal Reserve MBS holdings acquired from originators as a result of large-scale asset purchases can help stimulate economic activity through a so-called “solicited refinancing channel.” Finally, we provide an estimate of the additional refinancing activity resulting from the solicited refinancing channel in the years after the Federal Reserve’s first MBS purchase program, demonstrating that this channel conveyed savings on monthly mortgage payments to homeowners.

The trick to getting a bank to do your bidding is to convince it that it's ripping you off.

Suntory is struggling to integrate Jim Beam.

I feel like I've seen this movie; it's a clichéd but warm-hearted comedy that ends with everyone learning a valuable lesson about their shared humanity. Also there's whiskey:

“We have to overcome the huge differences in the Japanese mentality and the American mentality,” says Takeshi Niinami, a Harvard Business School graduate who last year became the first president of privately owned Suntory from outside the founding family. “It creates misunderstandings.”

Jim Beam master distiller Fred Noe, a seventh-generation Jim Beam family member and former roadie for Hank Williams Jr., caused some to cringe at a recent promotional event in Tokyo when he described Suntory executives as his “buddies” and embraced one of them. Japan frowns on physical contact in a business setting.

Goldman is selling its coal mines.

Did you even know that Goldman Sachs owned coal mines? It does, in Colombia, and they sound unpleasant: "Local women and children had formed a human blockade to protest labor issues, shutting down production," and "Goldman unsuccessfully sought help from the police and the military." Now it's trying to sell the mines at a loss. Disclosure: I used to work at Goldman, selling derivatives from a comfortable seat in an air-conditioned office building, and I would sometimes grumble things like "off to another day at the coal mines." Now I feel bad.

Things happen.

Shorting negative-yield bonds is a tough trade in part because it generates cash, which has an even more negative yield. Interest-Bearing Securities When Interest Rates are Below Zero. "The International Monetary Fund is close to declaring China’s yuan fairly valued," and China is liberalizing access to its domestic bond market. The Andreessen Horowitz star system, and "VC’s are going to start pressuring their struggling portfolio companies to return the capital rather than die a slow, pivot-filled death." Senior Supervisors Group: Algorithmic Trading Briefing Note. Derivatives Pricing under Bilateral Counterparty Risk. The Shale Boom Has Already Gone Bust - At Least For Now. Did Tesla nearly go bankrupt without investors knowing? How Big Bird escaped death on the doomed Challenger shuttle. Honest Subway Announcements. "What would Satan buy with Bitcoin?"

If you'd like to get Money Stuff in handy e-mail form, right in your inbox, please subscribe at this link. Thanks!

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net