Private Equity, Meet the AFA

When you buy a red car you start to see them everywhere.

Maybe this explains why when you are focused on competitive legal services you start to see signs of competition in other markets. Even those that are more parochial than corporate law firm services. If that is possible.

One market that may fit this bill: the clubby world of private equity and the university endowments that are some of their biggest investors. These funds have historically fought to get into some of the new investment vehicles promoted by leading private equity firms. Even in this market, things are starting to change.

Bloomberg covered this well by reporting on remarks by Sandra Robertson, head of Oxford University’s endowment at a recent industry conference. Ms. Robertson mentioned private equity firm Carlyle Group by name, mainly because one of its co-founders, William Conway, was also a speaker at the event.

At issue were the substantial fees that the private equity firms charge, often a “2/20.” That’s 2% of the client’s investment annually until the money is deployed, and 20% of the profits of investments made by the fund. Because of lowering rates of return, private equity is awash in cash, and is having a more difficult time finding investments that meet hurdle rates of return.

So if you are doing the math in your head, yes, a $1 billion fund with a 2% carry would throw off $20 million a year to the managers. Not bad for a start.

Where this gets interesting from an alternative fee perspective is that customers like Ms. Robertson are focusing on the additional fees charged by private equity firms beyond their 2/20. She explains:

“The resources and expenses investing through limited partnership structures is a pain in the backside,” she said. “It is as if you make it deliberately hard for us, you make it hard to get in, the tedious fundraising process, the fight for allocations, the pain of partnership documents, the fees. And not just the headline figure, all the tricks we have to look out for such as transaction fees, monitoring fees, fees for paying the fees for your software licenses, fees for visiting limited partners. Come on guys, pay your own bills.”

Ouch. This is actually very similar to what I hear from some general counsel when they describe an AFA negotiation. They think they are getting a better deal than standard rates billed by the hour, but they are not sure.

And if we think the billable hour model is of long lineage, here’s something else. Ms. Robertson explained the history of the up-front charge and the “carried interest:”

She also questioned the logic of the two-and-twenty fee structure, which traces its origins to when traders paid ships’ captains to risk their lives to transport goods overseas.

“There’s no longer an alignment of interest,” Robertson said. “You are no longer just paying the captain to sail on a ship. You pay the captain to live quite a different lifestyle.”

This is almost exactly how I have heard a few CFOs characterize paying many lawyers over $500 per hour.

The challenge for private equity firms is that returns are very easy to calculate and compare against alternative investments, like a small basket of low-cost index mutual funds. As recently noted in the New York Times:

… large, medium and small endowments all underperformed a simple mix of 60 percent stocks and 40 percent bonds over one-, three- and five-year periods. The 91 percent of endowments with less than $1 billion in assets underperformed in every time period since records have been maintained.

For the time being, law firms have an easier time in dealing with fee discussions without the transparency facing private equity firms in benchmarking returns against passive investments.

That is changing however, as more data and analytical tools become available to general counsel. I think law firms that meet this increasing competition will start to see clients as investors of a sort. Most corporate clients have a lot of options lawyer-wise and expect more than the “smart lawyers; many offices” pitch.

General counsel see a lot of law firms. So many that they start to look like red cars. You don’t want to be just another red car.

(But maybe an alternative vehicle, streamlined and lightweight. Only one lawyer, maybe two can fit. Note clock in the background, to remind us of the old regime. Nice shoes.)