Spotlight on private equity management fees

Can parent companies still charge management fees to their subsidiary companies?

1. Background

   • Recent case law (SSF Realisations Ltd (in liquidation) v Loch Fyne Oysters Ltd) has put management fees charged by parent companies to their subsidiaries under the spotlight.

   • In this case, the management fee was found to be a disguised distribution and therefore, as the subsidiary did not have sufficient distributable reserves when it was paid, had to be repaid.

2. Can private equity firms still charge management fees to their portfolio companies?

   • However, there are several steps that the parent company (or PE house) should take to mitigate risk:

     • the parent company should be providing actual value for the management fee (e.g. M&A services, head office services and actual management time invested);

     • the agreement should be documented; and

     • the arrangement should be on arm’s length terms.

   • In many circumstances the management company for a PE firm will not be the company that owns the subsidiary. In this situation, the management fee is not likely to be a disguised distribution:  however, there may be other concerns for directors of the subsidiary if the management fee is not a fair bargain.

3. What were the key facts of the case

   • Loch Fyne Oysters Ltd (“LFO”) was the only shareholder of the claimant, SSF Realisations Ltd (“Company”).

   • Over time, LFO became heavily indebted to the Company (the “Debt”) and it was decided to sell LFO. As part of the sale, the parties intended to clear the debt between LFO and the Company.

   • To repay the debt, it was decided that (i) the Company would pay an interim dividend to LFO (“Interim Dividend”); and (ii) the Company would pay a management charge to LFO in relation to various costs incurred by LFO for the benefit of the Company. These costs included staffing, selling discounted goods and various ancillary costs (“Management Charge”).

   • The Management Charge and the Interim Dividend (together the “Payments”) equalled the amount of the Debt and therefore they were to net off against each other.

   • The Company was found to be insolvent.

4. What was the company’s claim against LFO?

   • The Company brought a claim against LFO and five directors of the Company on the grounds that:

     • the Management Charge was a disguised distribution to LFO;

     • the Payments, when taken together, comprised an unlawful distribution of capital in breach of Part 23 CA 2006; and

     • LFO and three out of five of the Company's directors (“Directors”) were liable to compensate the Company and repay the unlawful distribution.

   • The Directors acknowledged that the Management Charge was raised purely for the purpose of eliminating the part of the LFO debt that was not offset against the interim dividend.

   • The Directors denied that the Management Charge not a proper charge, asserting that the costs had actually been incurred by LFO and were fair to recharge to the Company because the Company had received the benefit of the various items.

5. What was decided?

   • The court sided with the liquidators and said that the management charge was an interim dividend and therefore had to be repaid.

   • In coming to this conclusion, some of the key factors were:

     • was the management charge genuine?

     • did the parent company offer genuine services for the management fee?

     • was there a history of management charges being paid?

   • Ultimately in this case, it was all a bit too perfect – the Management Charge (together with the dividend) exactly netted off against the debt. As such, the court considered that it was de facto a dividend.

Please get in touch with Francis Dalton if you would like to discuss anything covered in this article this further.