The Untold Story of Sun Capital: Disguised Dividends
7 Pages Posted: 8 May 2014
Date Written: February 3, 2014
This article argues that portfolio companies controlled by private equity firms routinely misclassify "monitoring fees" paid to the firms as deductible compensation when in fact they are non-deductible dividends. In order to properly deduct amounts paid as compensation, the payor must make the payments with compensatory intent. However, the monitoring fee agreements often belie this intent. In nearly all cases, the fee agreements provide for large periodic fees over lengthy periods of time for future services described only in nebulous terms. The amount of fees are set well before it is known whether there will in fact be any need for these services (above and beyond what the portfolio company’s traditional management will be able to provide). The private equity firm is often explicitly granted the unilateral power to determine how much, if any, time or effort it must devote to these services, and the contracts usually specifically disclaim any minimum performance requirement (either in terms of hours worked or other performance metric). In addition, many monitoring fee agreements allow the private equity firm to unilaterally cancel the agreement at any time and for any reason yet still get paid the full value of the contract. Furthermore, when a consortium of private equity funds engages in a takeover, the monitoring fees are commonly shared among their sponsors in accordance with each fund’s proportional share ownership in the portfolio company.
These factors, and others that are typically present, are flatly inconsistent with an intent to pay compensation. In fact, one would be hard-pressed to find an arm’s length compensation-for-services arrangement that includes any of these terms. On the other hand, these factors all support dividend characterization. When combined with the common "management fee offset" provision found in private equity fund limited partnership agreements, these factors make clear that monitoring fees are in fact payments made by portfolio companies to benefit shareholders in their capacity as shareholders. In other words, monitoring fees are non-compensatory payments that benefit shareholders, also known as dividends.
Keywords: private equity, portfolio companies, management fee offsets, disguised dividends, compensatory intent
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